Problem 8-25 Calculating Project NPV
You have been hired as a consultant for Pristine Urban-Tech
Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for
zithers is growing quickly. The company bought some land three
years ago for $1.46 million in anticipation of using it as a toxic
waste dump site but has recently hired another company to handle
all toxic materials. Based on a recent appraisal, the company
believes it could sell the land for $1,560,000 on an aftertax
basis. At the end of the project, the land could be sold for
$1,660,000 on an aftertax basis. The company also hired a marketing
firm to analyze the zither market, at a cost of $131,000. An
excerpt of the marketing report is as follows:
The zither industry will have a rapid expansion in the next four
years. With the brand name recognition that PUTZ brings to bear, we
feel that the company will be able to sell 4,400, 5,300, 5,900, and
4,800 units each year for the next four years, respectively. Again,
capitalizing on the name recognition of PUTZ, we feel that a
premium price of $710 can be charged for each zither. Since zithers
appear to be a fad, we feel at the end of the four-year period,
sales should be discontinued.
PUTZ feels that fixed costs for the project will be $455,000 per
year, and variable costs are 15 percent of sales. The equipment
necessary for production will cost $4.1 million and will be
depreciated according to a three-year MACRS schedule. At the end of
the project, the equipment can be scrapped for $430,000. Net
working capital of $131,000 will be required immediately and will
be recaptured at the end of the project. PUTZ has a 40 percent tax
rate and the required return on the project is 13 percent. Refer to
Table 8.3.
What is the NPV of the project? (Do not round intermediate
calculations and round your answer to 2 decimal places, e.g.,
32.16.)
NPV $
Cost of hiring marketing firm is a sunk cost and not relevant for calculation of NPV | ||||||||||||
Initial Cash Flow: | ||||||||||||
Opportunity cost of land | $1,560,000 | |||||||||||
Cost of equipment | $4,100,000 | |||||||||||
Net working capital | $131,000 | |||||||||||
Total | $5,791,000 | |||||||||||
A | B | C=A*B | D=C*15% | E | F=C-D-E | G=(1-0.4)*F | ||||||
Sale in | Price per | Sales in | Variable | Fixed cost | Before tax | After Tax | ||||||
Year | Units | unit | dollars | cost | Profit | Profit | ||||||
1 | 4,400 | $710 | $3,124,000 | $468,600 | $455,000 | $2,200,400 | $1,320,240 | |||||
2 | 5,300 | $710 | $3,763,000 | $564,450 | $455,000 | $2,743,550 | $1,646,130 | |||||
3 | 5,900 | $710 | $4,189,000 | $628,350 | $455,000 | $3,105,650 | $1,863,390 | |||||
4 | 4,800 | $710 | $3,408,000 | $511,200 | $455,000 | $2,441,800 | $1,465,080 | |||||
A | B=A*$4.1million | C=B*40% | Tax Rate=40% | |||||||||
Depreciation | Amount of | Depreciation | ||||||||||
Year | Rate | Depreciation | Tax shield | |||||||||
1 | 33.33% | $1,366,530 | $546,612 | |||||||||
2 | 44.45% | $1,822,450 | $728,980 | |||||||||
3 | 14.81% | $607,210 | $242,884 | |||||||||
4 | 7.41% | $303,810 | $121,524 | |||||||||
After Tax Salvage Value | ||||||||||||
Before Tax Salvage Value | $430,000 | |||||||||||
After Tax Salvage Value | $258,000 | (430000*(1-0.4) | Present Value of Cash Flow=(Cash Flow)/((1+i)^A) | |||||||||
Terminal Cash Flow: | i=Required Return =13%=0.13 | |||||||||||
Sale of land | $1,660,000 | A=Year of Cash Flow | ||||||||||
Sale of equipment | $258,000 | |||||||||||
Release of working capital | $131,000 | A | B | C | D | E | F=B+C+D+E | G=E/(1.13^A) | ||||
Total terminal cash inflow | $2,049,000 | initial cash | After Tax | Depreciation | Terminal | Net | Present value | |||||
Year | flow | Profit | Tax shield | Cashflow | Cash flow | PV of cashflow | ||||||
0 | ($5,791,000) | ($5,791,000) | ($5,791,000) | |||||||||
1 | $1,320,240 | $546,612 | $1,866,852 | $1,652,081.42 | ||||||||
2 | $1,646,130 | $728,980 | $2,375,110 | $1,860,059.52 | ||||||||
3 | $1,863,390 | $242,884 | $2,106,274 | $1,459,753.54 | ||||||||
4 | $1,465,080 | $121,524 | $2,049,000 | $3,635,604 | $2,229,784.02 | |||||||
TOTAL | $1,410,678.49 | |||||||||||
NPV of the Project | $1,410,678.49 | |||||||||||
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