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

Cleveland	0	1	2	3	4	5
MACRS %		14.29%	24.49%	17.49%	12.49%	8.93%	22.31%
Unit Sales		340,000	355,000	355,000	355,000	100,000
VC		$         6.00	$             6.30	$         6.62	$         6.95	$        7.29
Investment	-$2,450,000						546,595
Salvage						$500,000
NWC	-$574,600	-$25,350	$0	$0	$430,950	$169,000
Sales		$4,420,000	$4,615,000	$4,615,000	$4,615,000	$1,300,000
VC		-$2,040,000	-$2,236,500	-$2,348,325	-$2,465,741	-$729,304
FC		-$610,000	-$646,600	-$685,396	-$726,520	-$770,111
Depreciation		-$350,105	-$600,005	-$428,505	-$306,005	-$218,785
EBT		$1,419,895	$1,131,895	$1,152,774	$1,116,734	-$418,200
Tax (21%)		-$298,178	-$237,698	-$242,083	-$234,514	$87,822
Net Income		$1,121,717	$894,197	$910,691	$882,220	-$330,378
Cash Flows	-$3,024,600	$1,446,472	$1,494,202	$1,339,196	$1,619,175	$567,192
NPV	$1,172,490.04

VC increases by 5% each year

NWC = 13% x Sales and additional NWC = difference in sales x 13%

FC increases by 6% each year

Depreciation = Investments x MACRS%

Cash Flows = Investment + NWC + Net Income + Depreciation + After-tax Salvage Value

NPV can be calculated using the same function in excel with 18% discount rate.

Cleveland	0	1	2	3	4	5
MACRS %		14.29%	24.49%	17.49%	12.49%	8.93%	22.31%
Unit Sales		380,000	380,000	380,000	380,000	380,000
VC		$         8.00	$             8.40	$         8.82	$         9.26	$         9.72
Investment	-$2,450,000						546,595
Salvage						$500,000
NWC	-$691,600	$0	$0	$0	$0	$691,600
Sales		$5,320,000	$5,320,000	$5,320,000	$5,320,000	$5,320,000
VC		-$3,040,000	-$3,192,000	-$3,351,600	-$3,519,180	-$3,695,139
FC		-$610,000	-$646,600	-$685,396	-$726,520	-$770,111
Depreciation		-$350,105	-$600,005	-$428,505	-$306,005	-$218,785
EBT		$1,319,895	$881,395	$854,499	$768,295	$635,965
Tax (21%)		-$277,178	-$185,093	-$179,445	-$161,342	-$133,553
Net Income		$1,042,717	$696,302	$675,054	$606,953	$502,412
Cash Flows	-$3,141,600	$1,392,822	$1,296,307	$1,103,559	$912,958	$1,922,582
NPV	$952,677.58