Question

Primrose has decided to sell a new line of golf clubs. The clubs will sell for $825 per set and have a variable cost of $370 per set. The company has spent $150,000 for a marketing study that determined the company will sell 74,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 8,900 sets per year of its high-priced clubs. The high-priced clubs sell for $1,250 and have variable costs of $630. The company will also increase sales of its cheap clubs by 11,000 sets per year. The cheap clubs sell for $375 and have variable costs of $140 per set. The fixed costs each year will be $14,350,000. The company has also spent $1,000,000 on research and development for the new clubs. The plant and equipment required will cost $29,400,000 and will be depreciated on a straight-line basis to zero (no salvage value). The new clubs will also require an increase in net working capital of $3,500,000 that will be returned at the end of the project. The tax rate is 40 percent, and the cost of capital is 14 percent. The initial cost is the equipment plus the net working capital, so: Initial cost = $32,900,000 = $29,400,000 + 3,500,000

1. Calculate the Payback Period. Would you accept or reject the project? Assume the company has a desired payback of 2 years.

Answer 1

Operating cash flow (OCF) each year = Incremental earnings after tax + depreciation

Incremental earnings after tax = Incremental earnings before tax - taxes

Incremental earnings before tax = revenues - variable costs - fixed costs - depreciation - decreased contribution of high-priced clubs + increased contribution of cheap clubs

Decreased contribution of high-priced clubs = lost sales units * (sale price - variable cost)

Increased contribution of cheap clubs = increased sales units * (sale price - variable cost)

In year 7, the entire working capital investment is recovered.

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period = 2 + (cash flow required in year 3 for cumulative cash flows to equal zero / year 3 cash flow) = 2 + ($9,875,600 / $11,512,200) = 2.86 years

The project would be rejected as the payback period is higher than the desired payback of 2 years.