Question

Hit or Miss Sports is introducing a new product this year. It is a see at night soccer ball. If the balls are a hit, the firm expects to be able to sell 50,000 balls at a price of 60$ each. If the new product is a bust, only 30,000 units can be sold at a price of $55. The variable cost of each ball is $30 and fixed costs are zero. The cost of the manufacturing equipment is $6 million and the project life is estimated at 10 years. The firm will use straight line depreciation. The firm’s tax rate is 35% and the discount rate is 12%

1. If each outcome is equally likely what is the expected NPV?
2. Now if the firm can abandon the project after 1 year if the sales are weak and sell of the remaining manufacturing equipment for 5.4 million, would this change the decision?

Answer 1

A. The NPV computations for the two scenarios is as given below:

Based on the above calculations, the company should not go ahead with the investment.

B. The cash flows assuming sale of equipment after 1 year is given below:

	Years
Particulars	0	1
Common assumptions
Variable cost per ball		30
Cost of equipment	-60,00,000
Depreciation per year		-6,00,000
Hit scenario
No. of balls sold		50,000
Rate per ball		60
Revenue		30,00,000
Variable cost		-15,00,000
Gross profit		15,00,000
Depreciation		-6,00,000
Operating profit		9,00,000
Tax @ 35%		-3,15,000
Net profit		5,85,000
Add back depreciation		6,00,000
Cost of equipment	-60,00,000	54,00,000
Net cash flows	-60,00,000	65,85,000
Discount factor @ 12%	100%	89%
Present value of cash flows	-60,00,000	58,79,464
Net present value of cash flows	-1,20,536
Probability of hit scenario	50%
Probability weighted NPV	-60,268	(A)
Loss scenario
No. of balls sold		30,000
Rate per ball		55
Revenue		16,50,000
Variable cost		-9,00,000
Gross profit		7,50,000
Depreciation		-6,00,000
Operating profit		1,50,000
Tax @ 35%		-52,500
Net profit		97,500
Add back depreciation		6,00,000
Cost of equipment	-60,00,000	54,00,000
Net cash flows	-60,00,000	60,97,500
Discount factor @ 12%	100%	89%
Present value of cash flows	-60,00,000	54,44,196
Net present value of cash flows	-5,55,804
Probability of hit scenario	50%
Probability weighted NPV	-2,77,902	(B)
Sum of probability weighted NPVs	-3,38,170	(A+B)

Based on the above, even if the equipment is saleable at USD 5,4 million at the end of one year, the company should still not go ahead with the investment.