## Financial management unit 4 IP

*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 pro**ject 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.

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