Question

RET Inc. currently has one product, low-priced stoves. RET Inc. has decided to sell a new line of medium-priced stoves. Sales revenues for the new line of stoves are estimated at $30 million a year. Variable costs are 75% of sales. The project is expected to last 10 years. Also, non-variable costs are $4,000,000 per year. The company has spent $1,000,000 in research and a marketing study that determined the company will lose (cannibalization) $10 million in sales a year of its existing low-priced stoves. The production variable cost of the existing low-priced stoves is $8 million a year.

The plant and equipment required for producing the new line of stoves costs $10,000,000 and will be depreciated down to zero over 20 years using straight-line depreciation. It is expected that the plant and equipment can be sold (salvage value) for $6,000,000 at the end of 10 years. The new stoves will also require today an increase in net working capital of $2,000,000 that will be returned at the end of the project.

The tax rate is 40 percent and the cost of capital is 10%.

1.) What is the project's cash flow for year 10 for this project?

2.) What is the Net Present Value (NPV) for this project?

Answer 1

Particulars	Years
	1	2	3	4	5	6	7	8	9	10
Revenue	30	30	30	30	30	30	30	30	30	30
Variable costs	22.5	22.5	22.5	22.5	22.5	22.5	22.5	22.5	22.5	22.5
Contribution	7.5	7.5	7.5	7.5	7.5	7.5	7.5	7.5	7.5	7.5
Fixed costs	4	4	4	4	4	4	4	4	4	4
Loss in revenue	2	2	2	2	2	2	2	2	2	2
Depreciation	0.4	0.4	0.4	0.4	0.4	0.4	0.4	0.4	0.4	0.4
Operating Profit	1.1	1.1	1.1	1.1	1.1	1.1	1.1	1.1	1.1	1.1
Tax @ 40%	0.44	0.44	0.44	0.44	0.44	0.44	0.44	0.44	0.44	0.44
Depreciation	0.4	0.4	0.4	0.4	0.4	0.4	0.4	0.4	0.4	0.4
Cash flows	1.06	1.06	1.06	1.06	1.06	1.06	1.06	1.06	1.06	1.06
Return of working capital	0	0	0	0	0	0	0	0	0	2
Salvage value of machine	0	0	0	0	0	0	0	0	0	6
Total cash flow	1.06	1.06	1.06	1.06	1.06	1.06	1.06	1.06	1.06	9.06
Discounting Factor	0.909091	0.826446	0.751315	0.683013	0.620921	0.564474	0.513158	0.466507	0.424098	0.385543
Present value	0.963636	0.876033	0.796394	0.723994	0.658177	0.598342	0.543948	0.494498	0.449543	3.493022

1) Project cash flow for year 10 = Normal cash flows from operations + salvage value of machine + return of working capital

= 1.06 + 2 + 6 =$9.06 M

2) NPV of the project = Present value of cash inflows - present value of cash outflows

= 9.60 - 10 - 2 =-$2.40 M

Note : Cost of research is not considered as it is a sunk cost.