Question

Cleveland Enterprises is considering the addition of a new product line.  The firm would not need additional factory space, but it would require the purchase of $2.45 million of equipment installed.  The equipment would be depreciated using a 7-year accelerated depreciation schedule.  Additional inventory of 13% of the projected increase in next year’s sales would be necessary prior to each year of operation, but the entire value will be recovered at the end of the project.  The firm expects to sell 340,000 units during the first year of the project, increasing to 355,000 units during the next three years before decreasing to 100,000 during the fifth and final year of the project.  The product is expected to be obsolete at that point.  The expected sales price is $13 per unit with a variable cost of $6 per unit during the first year of operations.  Variable costs will increase by 5% per year, but the sales price remains fixed.  Fixed costs are estimated at $610,000 during the first year, but will increase by 6% per year.  The firm’s tax rate is 21%.  The equipment has an estimated salvage value of $500,000.

What is the estimated net present value of the project assuming a required return of 18%?

Management of the firm is predicting the possibility of an economic boom during the upcoming years.  If so, the projected sales would be 380,000 units per year with a price of $14.  However, it would also increase labor costs giving the firm a variable cost per unit of $8 in the first year, with subsequent increases as discussed above.  

What is the estimated net present value of the project assuming an economic boom?

Based on your calculations, what recommendations would you make to the management of Cleveland Enterprises?

**NOTE FROM STUDENT: Can you please show all the formulas entered in the spreadsheet so I may enter them in as well and understand how to do them?***

Answer 1

Operating cash flow (OCF) each year = income after tax + depreciation - change in working capital

loss on sale of equipment at end of year 5 = book value - sale price

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value + tax benefit on loss on sale of equipment (the loss is tax deductible, and hence reduces the tax outgo. This is treated as a cash inflow)

NPV is calculated using NPV function in Excel

NPV is $1,747,090

Economic boom

NPV is $1,644,278

The NPV during an economic boom is lower than the NPV during normal conditions.

Therfore, it is recommended to the management to take advantage of the increased sales during a boom to increase the NPV during an economic boom. This could be done by possibly lowering the variable cost or increasing the sale price.