Question

The Scenario:

You work in the product development department of an athletic apparel company. Your company has decided to add a new product and is choosing between a polo tee, yoga pants, or running shoes.

You have been asked to evaluate the financial profitability of each option. You have estimated that the company has $1,500,000 to invest in the project, and each product has the potential to bring in an estimated $2,000,000 of future cash flows, although the timing of the cash flows varies per product.

Additionally, two of the products would use equipment that could be sold at the end of the project cycle. In order to pay for the project, the company will have to finance at a 6% interest rate. Present value discount factors are listed as follows:

Years	PV of 1 at 6%	PV of an Annuity at 6%
1	0.94340	0.94340
2	0.89000	1.83339
3	0.83962	2.67301
4	0.79209	3.46511
5	0.74726	4.21236

Formulas:

	NPV = PV of total future net CF’s – initial cost

Requirements

1. Calculate the profitability of each project using

• The payback method
• Net present value (NPV)

2. Make a decision on which product to produce by answering the Pause and Reflect questions on page 5.

Option 1: Polo Shirts

Future Net Cash Flows
Year 1	$400,000
Year 2	$400,000
Year 3	$400,000
Year 4	$400,000
Year 5	$400,000

Today’s Cash Outflows
Initial investment	$1,500,000

1. Calculate the payback period of polo shirts. In other words, how many years will it take for the company to recoup the initial investment?

2. Calculate the NPV of polo shirts. In other words, when comparing apples to apples (the present value of cash inflows to the present value of cash outflows), what will the expected profit of the project be?

Option 2: Yoga Pants

Future Net Cash Flows
Year 1	$500,000
Year 2	$500,000
Year 3	$500,000
Year 4	$500,000
Salvage Value of Equipment	$50,000

Today’s Cash Outflows
Initial investment	$1,500,000

3. Calculate the payback period of yoga pants. Because the equipment will be sold in the 4^th year, the cash flows for each year will not be the same (they are the same for years 1-3, but not for year 4). Use the following setup to calculate the payback period for a project with unequal cash flows:

Year	Annual Net Cash Flow	Cumulative Net Cash Flows
1
2
3
4

4. Calculate the NPV of polo shirts.

1. Notice that for all four years the company will receive the same cash flow provided by the product. Use the PV of an annuity discount factor for this part of the calculation.

1. Notice also that the company will sell equipment in the 4^th year for an additional cash flow. Which present value table should you use when calculating a single sum? Add this amount to the PV found in part a) to determine the PV of total net cash flows.

Option 3: Running Shoes

Future Net Cash Flows
Year 1	$300,000
Year 2	$600,000
Year 3	$750,000
Year 4	$350,000
Salvage Value of Equipment	$50,000

Today’s Cash Outflows
Initial investment	$1,500,000

5. Calculate the payback period of running shoes.

Year	Annual Net Cash Flow	Cumulative Net Cash Flows
1
2
3
4

6. Calculate the NPV of running shoes.

1. Notice that every year the company will receive a different cash flow. In order to calculate the PV of the total net cash flows, you will need to take the individual PV of each future cash flow and add them together.

Pause and Reflect:

1. Which product has the best NPV? Which has the best payback period? Is there anything about these results that surprises you?

2. If given the opportunity to choose between a higher NPV or a lower payback period, which would you choose and why?

3. Based on the information above, our company chooses to make _____________________

4. How did having a salvage value (such as with the yoga pants and running shoes) affect your payback and NPV calculations?

5. List two things that you learned from participating in this activity.

Answer 1

Option 1: Polo Shirts
Year	Net Cash Flows	PV of 1 at 6%	Present Value
Year 0	($1,500,000)	1	($1,500,000)
Year 1	$400,000	0.9434	$377,360
Year 2	$400,000	0.89	$356,000
Year 3	$400,000	0.83962	$335,848
Year 4	$400,000	0.79209	$316,836
Year 5	$400,000	0.74726	$298,904
		NPV	$184,948
Alternate Method
NPV = -$1,500,000 + $400,000 x 4.21236	$184,944
Year	Annual Net Cash Flow	Cumulative Net Cash Flows
0	($1,500,000)	($1,500,000)
1	$400,000	($1,100,000)
2	$400,000	($700,000)
3	$400,000	($300,000)
4	$400,000	$100,000
5	$400,000
Payback Period = 3 + 300000/400000	3.75	years
Option 2: Yoga Pants
Year	Net Cash Flows	PV of 1 at 6%	Present Value
Year 0	($1,500,000)	1	($1,500,000)
Year 1	$500,000	0.9434	$471,700
Year 2	$500,000	0.89	$445,000
Year 3	$500,000	0.83962	$419,810
Year 4	$500,000	0.79209	$396,045
Salvage Value	$50,000	0.79209	$39,605
		NPV	$272,160
Alternate Method
NPV = -$1,500,000 + $500,000 x 3.46511 + 50000 x .79209	$272,159.50
Year	Annual Net Cash Flow	Cumulative Net Cash Flows
0	($1,500,000)	($1,500,000)
1	$500,000	($1,000,000)
2	$500,000	($500,000)
3	$500,000	$0
4	$500,000	$500,000
Payback Period =	3.00	years
Option 3: Running Shoes
Year	Net Cash Flows	PV of 1 at 6%	Present Value
Year 0	($1,500,000)	1	($1,500,000)
Year 1	$300,000	0.9434	$283,020
Year 2	$600,000	0.89	$534,000
Year 3	$750,000	0.83962	$629,715
Year 4	$350,000	0.79209	$277,232
Salvage Value	$50,000	0.79209	$39,605
		NPV	$263,571
Year	Annual Net Cash Flow	Cumulative Net Cash Flows
0	($1,500,000)	($1,500,000)
1	$300,000	($1,200,000)
2	$600,000	($600,000)
3	$750,000	$150,000
4	$350,000	$500,000
Payback Period = 3 + 600000/750000	2.80	years
Option	NPV	Payback Period in years
Polo Shirt	$184,948	3.75
Yoga Pants	$272,160	3.00
Running shoes	$263,571	2.80
Yoga Pants has the best NPV
Running shoes has the best packback period
The only thing surprises me is Yoga pants has higher NPV but its payback period is higher than the Running shoes option but Running shoes has lower NPV than the yoga pants.
Based on the information above, our company chooses to make Yoga Pants because it has higher NPV ,  the value of future cash flows to reflect what they're worth in the present day.
Salvage Value increases the future cash inflow and it has increased the NPV.In this activity salavage value doesn't have any impact on payback period
2 things that I learned here is about NPV and Payback period