Manufacturing company is thinking of launching a new product. The company expects to sell $950,000 of the new product in the first year and $1,500,000 each year thereafter. Direct costs including labor and materials will be 55% of sales. Indirect incremental costs are estimated at $80,000 a year. The project requires a new plant that will cost a total of $1,000,000, which will be a depreciated straight line over the next 5 years. The new line will also require an additional net investment in inventory and receivables in the amount of $200,000.
Assume there is no need for additional investment in building the land for the project. The firm’s marginal tax rate is 35%, and its cost of capital is 10%.
A. Prepare a statement showing the incremental cash flows for this project over an 8-year period.
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
|---|---|---|---|---|---|---|---|---|
| Revenue | $950,000 | $1,500,000 | $1,500,000 | $1,500,000 | $1,500,000 | $1,500,000 | $1,500,000 | $1,500,000 |
| Expenses: | ||||||||
| Direct costs | $522,500 | $825,000 | $825,000 | $825,000 | $825,000 | $825,000 | $825,000 | $825,000 |
| Indirect incremental costs | $80,000 | $80,000 | $80,000 | $80,000 | $80,000 | $80,000 | $80,000 | $80,000 |
| Depreciation | $200,000 | $200,000 | $200,000 | $200,000 | $200,000 | |||
| Profit before tax | $147,500 | $395,000 | $395,000 | $395,000 | $395,000 | $595,000 | $595,000 | $595,000 |
| Tax | $51,625 | $138,250 | $138,250 | $138,250 | $138,250 | $208,250 | $208,250 | $208,250 |
| Profit after tax | $95,875 | $256,750 | $256,750 | $256,750 | $256,750 | $386,750 | $386,750 | $386,750 |
| Year | – | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
|---|---|---|---|---|---|---|---|---|---|
| Profit after tax | $95,875 | $256,750 | $256,750 | $256,750 | $256,750 | $386,750 | $386,750 | $386,750 | |
| Add: | |||||||||
| Depreciation | $200,000 | $200,000 | $200,000 | $200,000 | $200,000 | $0 | $0 | $0 | |
| Initial outlay | -$1,000,000 | ||||||||
| Additional investment | -$200,000 | ||||||||
| Net cash flow | -$1,200,000 | $295,875 | $456,750 | $456,750 | $456,750 | $456,750 | $386,750 | $386,750 | $386,750 |
B. Calculate the payback period (P/B) and the net present value (NPV) for the project.
| Year | Cash flow | Outstanding balance |
|---|---|---|
| 0 | ($1,200,000) | ($1,200,000) |
| 1 | $295,875 | ($904,125) |
| 2 | $456,750 | ($447,375) |
| 3 | $456,750 | $9,375 |
| 4 | $456,750 | $466,125 |
| 5 | $456,750 | $922,875 |
| 6 | $386,750 | $1,309,625 |
| 7 | $386,750 | $1,696,375 |
| 8 | $386,750 | $2,083,125 |
| Payback period | 2 Years, 11 Months |
| Year | Cash flow | Discount rate | Discount factor | Discounted cash flow |
|---|---|---|---|---|
| 0 | ($1,200,000) | 10% | 1.00 | ($1,200,000) |
| 1 | $295,875 | 10% | 1.10 | $268,977 |
| 2 | $456,750 | 10% | 1.21 | $377,479 |
| 3 | $456,750 | 10% | 1.33 | $343,163 |
| 4 | $456,750 | 10% | 1.46 | $311,966 |
| 5 | $456,750 | 10% | 1.61 | $283,606 |
| 6 | $386,750 | 10% | 1.77 | $218,310 |
| 7 | $386,750 | 10% | 1.95 | $198,464 |
| 8 | $386,750 | 10% | 2.14 | $180,422 |
| Net present value | $982,388 |
Answer the following questions based on your P/B and NPV calculations:
1. Do you think the project should be accepted? Why? Assume the company has a P/B (payback) policy of not accepting projects with life of over 3 years.
From the above calculations, you will observe that the net present value is above zero. Under the NPV (net present value) rule a project is acceptable only if its value is above zero. The NPV technique shows the firm what it would earn as “profit” if the project is undertaken.
Also from the P/B calculations, you will observe that the period is below the minimum cut-off period of 3 years.
Essentially under the NPV and P/B basis, the project would have to be accepted.
2. If the project required additional investment in land and building, how would this affect your decision? Explain.
Any additional investments would invariably increase the total initial outlay. This would in turn reduce the payback period and also the net present value determined in the previous sections.
Place an Order
Plagiarism Free!
Create an Account
Create an account at Top Tutor Online
- Allows you to track orders.
- Receive personal messages.
- Send messages to a tutor.
Post a Question/ Assignment
Post your specific assignment
- Tutors will be notified of your assignment.
- Review your question and include all the details.
- A payment Link will be sent to you.
Wait for your Answer!
Make payment and wait for your answer
- Make payment in accordance with the number of pages to be written.
- Wait for your Answer as a professional works on your paper.
- You will be notified when your Answer is ready.