Question

Rusty Williams, the owner and CEO of The Rusty Bicycle Company, a small manufacturer and distributer of recreational bikes, has dejectedly watched sales of his company’s flagship bike, the WindRunner, decline precipitously over the past 7 years. Believing that the trend is irreversible, Rusty has taken the drastic step of shutting down the operation of his firm in an effort to reduce costs while he tries to figure out how to rescue the firm he has spent the bulk of his life building.

Rusty asks his brother John, the head design engineer at his firm to design and build a prototype of a new bicycle that might be able to save the company. Rusty tells John to forget about conventional bicycle design and to “think big” and come up with something truly revolutionary.

After about 6 weeks of intense work, John comes back to Rusty with a proposal for the “WindRunner 2.0”, a bicycle unlike anything else on the market today. John believes that the specialty nature of the new bicycle suggests that, while unit sales volume may be relatively low, the bicycle should command a premium sales price. Specifically, he thinks that customers would be willing to pay upwards of $845 per bike.

Rusty, intrigued by the new design, hires a market research consultant, Sandy Frazier, to study the potential demand for the WindRunner 2.0. As projecting demand for a completely new product is notoriously difficult, she limits her prediction to a 5 year horizon. Sandy gives the following forecast to Rusty in exchange for her customary fee of $45,000.

Year	Sales Volume
1	7,000
2	7,000
3	7,000
4	7,000
5	7,000

Rusty is optimistic that the expected sales revenue will be enough to save his company. Deciding to move forward on the evaluation of this project, he asks John what new manufacturing capacity will be needed to begin production. John thinks that he could reconfigure the firm’s current manufacturing facility to produce the new model bicycle, although the current production machinery, purchased over 20 years ago, is woefully inadequate. He estimates that the necessary new equipment could be purchased for $2.5 million and that the whole manufacturing process will incur fixed operating costs of $3 million per year. Additionally, he estimates the variable costs of production to run $260 per bike produced.

John further thinks that the existing production equipment, which will no longer be needed, could be sold for $400,000. The existing equipment was classified for tax purposes under the 15 year MACRS category. As a result of a recent exemption given to small businesses, Rusty will not have to use the MACRS depreciation schedules for new capital assets acquired. Instead, the new equipment will be depreciated straight-line to zero over the 5 year planning horizon. John thinks that the new production equipment will be worthless and scrapped at the end of 5 years.

Finally, John tells Rusty that he will need about $300,000 in raw materials (i.e. parts and supplies) for the bicycles to begin production. This expenditure will not be recovered at the end of the project. Rusty, worried about spending so much cash on parts, calls a supplier, Rodney Murdock, to see about short-term credit options. Unfortunately, due to the precarious position Rusty finds his company in, the supplier is unable to offer any credit terms and will insist upon cash on delivery payment for raw materials.

Recently, a federal government economic stimulus measure was enacted. As a result of this effort, small businesses, like Rusty, will have their business income tax rate cut to zero percent for the next 10 years. The intent is to stimulate the formation of new small businesses throughout the country. Since this project is a last ditch effort to save the company, Rusty plans to let the project run for the 5 year forecast horizon. After that, he plans to dissolve the business and retire. Due to the desperation involved in this project, Rusty estimates that a 20% required rate of return is appropriate.

Rusty has asked for your help in addressing the following questions.

Prepare a 5 year forecast of cash flow from assets (CFA) for the WindRunner 2.0 project.

	1	2	3	4	5
Sales Volume
Price
Revenue
Fixed Costs
Variable Costs per unit

Income Statement	1	2	3	4	5
Sales
Expenses
Depreciation
EBIT
Taxes
Net Income

Cash Flows	0	1	2	3	4	5
Operating Cash Flows
Net Working Capital
Capital Expenditure
Salvage
Cash Flow from Assets

Calculate the Net Present Value (NPV) of the WindRunner 2.0 project.

Since the future of his company rests on the success or failure of this project, Rusty is understandably concerned about risks to his forecasts and expectations for the project. To get a better picture of the risk involved, Rusty again asks you to conduct the following scenario analyses.   

With your previous work being used as the ‘base case’ scenario, estimate the net present value of the project under a pessimistic scenario. Specifically, Rusty wants to consider the project’s NPV if both sales volume and the sales price are 10% below the base case scenario, while variable costs are 10% above the base case scenario estimates. All other variables will remain the same.

	1	2	3	4	5
Sales Volume
Price
Revenue
Fixed Costs
Variable Costs per unit

Income Statement	1	2	3	4	5
Sales
Expenses
Depreciation
EBIT
Taxes
Net Income

Cash Flows	0	1	2	3	4	5
Operating Cash Flows
Net Working Capital
Capital Expenditure
Salvage
Cash Flow from Assets

Now, to look at the optimistic case, reevaluate the project NPV where sales volume and sales price are 10% above the base case estimates, while variable costs are 10% below base case estimates. Again, all other variables are presumed to remain the same.

	1	2	3	4	5
Sales Volume
Price
Revenue
Fixed Costs
Variable Costs per unit

Income Statement	1	2	3	4	5
Sales
Expenses
Depreciation
EBIT
Taxes
Net Income

Cash Flows	0	1	2	3	4	5
Operating Cash Flows
Net Working Capital
Capital Expenditure
Salvage
Cash Flow from Assets

Finally, Rusty would like to know what minimum quantity of the WindRunner 2.0 models will have to be sold in order to produce a zero NPV (i.e. the financial breakeven point). That is, he would like to know what level of sales volume would leave him indifferent between undertaking the project versus shelving the project.  

Answer 1

5 year forecast of cash flow from assets (CFA) for the WindRunner 2.0 project

	1	2	3	4	5
Sales volume	7000	7000	7000	7000	7000
price	$845	$845	$845	$845	$845
revenue	$59,15,000	$59,15,000	$59,15,000	$59,15,000	$59,15,000
fixed costs	$30,00,000	$30,00,000	$30,00,000	$30,00,000	$30,00,000
variable cost per unit	$260	$260	$260	$260	$260

Income Statement	1	2	3	4	5
Sales	$59,15,000	$59,15,000	$59,15,000	$59,15,000	$59,15,000
Expenses
Variable expenses	$18,20,000	$18,20,000	$18,20,000	$18,20,000	$18,20,000
Fixed expenses	$30,00,000	$30,00,000	$30,00,000	$30,00,000	$30,00,000
Depreciation	$5,00,000	$5,00,000	$5,00,000	$5,00,000	$5,00,000
EBIT	$5,95,000	$5,95,000	$5,95,000	$5,95,000	$5,95,000
Taxes	$0	$0	$0	$0	$0
Net income	$5,95,000	$5,95,000	$5,95,000	$5,95,000	$5,95,000

Working notes:

Deprciation = 2500000 / 5 = $50000

Cash flows	0	1	2	3	4	5
Operating cash flows		$10,95,000	$10,95,000	$10,95,000	$10,95,000	$10,95,000
Net working capital	-$3,00,000
Capital expenditure	-$25,00,000
Salvage	$4,00,000
Cash flows from assets	-$24,00,000	$10,95,000	$10,95,000	$10,95,000	$10,95,000	$10,95,000

NPV of the project

	0	1	2	3	4	5
Cash flows from assets	-$24,00,000	$10,95,000	$10,95,000	$10,95,000	$10,95,000	$10,95,000
Cost of capital	$1.000	$0.833	$0.694	$0.579	$0.482	$0.402
PV of cash flows	-$24,00,000.0	$9,12,500.0	$7,60,416.7	$6,33,680.6	$5,28,067.1	$4,40,055.9

NPV = sum of PV of cash flows

= $8,74,720

Scenario Analysis

NPV under pessimistic scenario where sales volume and sales price are down by 10% and variable expenses are up by 10%

At sales level of 6500 units, the NPV will be 0. This has been calculaed by trial and error method.

	1	2	3	4	5
Sales volume	6300	6300	6300	6300	6300
price	$761	$761	$761	$761	$761
revenue	$47,91,150	$47,91,150	$47,91,150	$47,91,150	$47,91,150
fixed costs	$30,00,000	$30,00,000	$30,00,000	$30,00,000	$30,00,000
variable cost per unit	$286	$286	$286	$286	$286
Income Statement	1	2	3	4	5
Sales	$47,91,150	$47,91,150	$47,91,150	$47,91,150	$47,91,150
Expenses
Variable expenses	$18,01,800	$18,01,800	$18,01,800	$18,01,800	$18,01,800
Fixed expenses	$30,00,000	$30,00,000	$30,00,000	$30,00,000	$30,00,000
Depreciation	$5,00,000	$5,00,000	$5,00,000	$5,00,000	$5,00,000
EBIT	-$5,10,650	-$5,10,650	-$5,10,650	-$5,10,650	-$5,10,650
Taxes	$0	$0	$0	$0	$0
Net income	-$5,10,650	-$5,10,650	-$5,10,650	-$5,10,650	-$5,10,650
Cash flows	0	1	2	3	4	5
Operating cash flows		-$10,650	-$10,650	-$10,650	-$10,650	-$10,650
Net working capital	-$3,00,000
Capital expenditure	-$25,00,000
Salvage	$4,00,000
Cash flows from assets	-$24,00,000	-$10,650	-$10,650	-$10,650	-$10,650	-$10,650
Cost of capital	1	0.83333333	0.69444444	0.5787037	0.48225309	0.40187757
PV of cash flows	-$24,00,000	-$8,875	-$7,396	-$6,163	-$5,136	-$4,280

NPV = -$24,31,850

Scenario analysis for optimistic case where sale volume and price are 10% above and variable costs are 10% lower.

	1	2	3	4	5
Sales volume	7700	7700	7700	7700	7700
price	$930	$930	$930	$930	$930
revenue	$71,57,150	$71,57,150	$71,57,150	$71,57,150	$71,57,150
fixed costs	$30,00,000	$30,00,000	$30,00,000	$30,00,000	$30,00,000
variable cost per unit	$234	$234	$234	$234	$234
Income Statement	1	2	3	4	5
Sales	$71,57,150	$71,57,150	$71,57,150	$71,57,150	$71,57,150
Expenses
Variable expenses	$18,01,800	$18,01,800	$18,01,800	$18,01,800	$18,01,800
Fixed expenses	$30,00,000	$30,00,000	$30,00,000	$30,00,000	$30,00,000
Depreciation	$5,00,000	$5,00,000	$5,00,000	$5,00,000	$5,00,000
EBIT	$18,55,350	$18,55,350	$18,55,350	$18,55,350	$18,55,350
Taxes	$0	$0	$0	$0	$0
Net income	$18,55,350	$18,55,350	$18,55,350	$18,55,350	$18,55,350
Cash flows	0	1	2	3	4	5
Operating cash flows		$23,55,350	$23,55,350	$23,55,350	$23,55,350	$23,55,350
Net working capital	-$3,00,000
Capital expenditure	-$25,00,000
Salvage	$4,00,000
Cash flows from assets	-$24,00,000	$23,55,350	$23,55,350	$23,55,350	$23,55,350	$23,55,350
Cost of capital	1.000	0.833	0.694	0.579	0.482	0.402
PV of cash flows	-$24,00,000	$19,62,792	$16,35,660	$13,63,050	$11,35,875	$9,46,562

NPV = $46,43,938