Question

A company is considering manufacturing new elliptical trainers. This company did a marketing research 2 years ago, paying $750,000 consulting fees and found that the market is ripe for such a new product. The company feels that they can sell 5,000 of these per year for 5 years (after which time this project is expected to shut down). The elliptical trainers would sell for $ 2,000 each and have a variable cost of $500 each. The annual fixed costs associated with production would be $1,000,000. In addition, there would be a $5,000,000 initial expenditure associated with the purchase of new production equipment. It is assumed that this initial expenditure will be depreciated using the straight- line method down to zero over 5 years. This project will also require a one- time initial investment of $1,000,000 in working capital associated with inventory. The introduction of this new elliptical trainer will reduce the sales of an existing training machine that the company currently sells. The company estimates that $250,000 per year before tax basis will be lost on this existing training machine if the new elliptical trainer is introduced. At the end of the 5th year, the company estimates selling the production equipment for $150,000. Finally, assume that the firm’s marginal tax rate is 34 percent.

1. a) What is the initial outlay associated with this project?

2. b) What are the annual after- tax operating cash flows associated with this project for years

   1 through 4?

3. c) What is the non-operating cash flow in year 5 or the terminal value?

4. d) What is the project’s NPV given a 10 percent cost of capital?

Answer 1

Elliptical	0	1	2	3	4	5
Invesment	-$5,000,000
NWC	-$1,000,000					$1,000,000
Salvage						$150,000
Sales		$10,000,000	$10,000,000	$10,000,000	$10,000,000	$10,000,000
VC		-$2,500,000	-$2,500,000	-$2,500,000	-$2,500,000	-$2,500,000
FC		-$1,000,000	-$1,000,000	-$1,000,000	-$1,000,000	-$1,000,000
Cannibalization		-$250,000	-$250,000	-$250,000	-$250,000	-$250,000
Depreciation		-$1,000,000	-$1,000,000	-$1,000,000	-$1,000,000	-$1,000,000
EBT		$5,250,000	$5,250,000	$5,250,000	$5,250,000	$5,250,000
Tax (34%)		-$1,785,000	-$1,785,000	-$1,785,000	-$1,785,000	-$1,785,000
Net Income		$3,465,000	$3,465,000	$3,465,000	$3,465,000	$3,465,000
Cash Flows	-$6,000,000	$4,465,000	$4,465,000	$4,465,000	$4,465,000	$5,564,000
NPV	$11,608,255.46

Initial Outlay = -5,000,000 - 1,000,000 = -6,000,000

OCF = Net Income + Depreciation = 4,465,000

Non-operating cash flows in year 5 = NWC + Salvage x (1 - tax) = 1,000,000 + 150,000 x (1 - 34%) = $1,099,000

NPV can be calculated using 10% discount rate and above cash flows on a calculator or using formula