Question

Hole-in-One Inc. is considering expanding its golf ball business. Each pack of golf balls contains 3 balls. The company has projected the following information:

• Sales of 2,000,000 packs per year at $6 per pack.
• Total costs per pack is $4.  
• The project has a 5 year life.
• The required new equipment costs $15,000,000. This equipment will be depreciated straight line to zero over the life of the project. Another firm has made an offer to purchase the equipment at the end of the project for $1,000,000, which the company plans to accept.
• Initial change in net working capital is $1,000,000 and 50% will be recovered in the terminal year.
• The firm’s required rate of return is 8%.
• The firm’s tax rate is 21%.

1. What is the project's NPV?

2.   If the company decided that the riskiness of the project was more than originally expected, and it decided to increase the discount rate to 8.1%, would it accept or reject the project?

Answer 1

Answer for (1)

Calculation of depreciation on equipment

we are depreciating the equipment straight line to zero

depreciation per year = $15,000,000 / 5 = $3,000,000 per year

Calculation of initial outlay of the project

Investment in equipment + investment in working capital

= $15,000,000 + $1,000,000

= $16,000,000

Calculation of operational cash flow per year(calculated for 2,000,000 units)

particulars	Cash flows
Sales	$ 1,20,00,000.00	(2,000,000*6)
Variable cost	$   -80,00,000.00	(2,000,000*4)
Contribution	$     40,00,000.00
Depreciation	$   -30,00,000.00
Profit before tax	$     10,00,000.00
Tax	$      -2,10,000.00
Profit after tax	$       7,90,000.00
Add back depreciation	$     30,00,000.00
Net Cash flow	$     37,90,000.00

Calculation of cash flow of last year apart from operational cash flows

sales proceedes from sale of equipment after tax

= Salvage value - [(Salvage value - book value of equipment)*21%]

= $1,000,000 - [($1,000,000 - 0 ) * 21%]

= $790,000

working realesed at the end of project = 50% = $500,000

total Cash flow = sale proceedes of equipment + release of working capital

= $790,000 + $500,000

= $1,290,000

We assumed that there will be tax on capital gain.

Calculation of NPV with 8% rate of return

Year	Cash flows	Discounting factor @ 8%		Present Value
0	$ -1,60,00,000.00	1.0000	1(1.08)^0	$ -1,60,00,000.00
1	$       37,90,000.00	0.9259	1(1.08)^1	$       35,09,259.26
2	$       37,90,000.00	0.8573	1(1.08)^2	$       32,49,314.13
3	$       37,90,000.00	0.7938	1(1.08)^3	$       30,08,624.19
4	$       37,90,000.00	0.7350	1(1.08)^4	$       27,85,763.14
5	$       37,90,000.00	0.6806	1(1.08)^5	$       25,79,410.32
5	$       12,90,000.00	0.6806	1(1.08)^5	$         8,77,952.32
			Net present value	$             10,323.36

NPV is $10,323.36 there for company should accept the project.

Answer for (2)

Calculation of NPV with 8.1% rate of return

Year	Cash flows	Discounting factor @ 8.1%		Present Value
0	$ -1,60,00,000.00	1.0000	1(10.081)^0	$ -1,60,00,000.00
1	$       37,90,000.00	0.9251	1(10.081)^1	$       35,06,012.95
2	$       37,90,000.00	0.8558	1(10.081)^2	$       32,43,305.23
3	$       37,90,000.00	0.7916	1(10.081)^3	$       30,00,282.36
4	$       37,90,000.00	0.7323	1(10.081)^4	$       27,75,469.34
5	$       37,90,000.00	0.6774	1(10.081)^5	$       25,67,501.70
5	$       12,90,000.00	0.6774	1(10.081)^5	$         8,73,899.00
			Net present value	$           -33,529.43

NPV is -$33,529.43 therefore company should not accept the project.