Question

Samwise Gamgee is the financial manager for Fellowship Tours and Expeditions (aka “Fellowship”), a company that specializes in developing and leading group tours throughout Middle Earth. Fellowship creates tour packages, markets these packages, and leads the various tours to places like Rivendell, the Lonely Mountain, Gondor, and Mirkwood. The current tours are very successful and Frodo, the CEO of Fellowship has proposed introducing a new tour package. The new package will be a tour to Mordor where tourists can see the beauty of the fiery chasm of Mount Doom as well as see Orc in their natural environment. Samwise has been charged with evaluating the potential value of this project.

Sam has prepared the following estimates related to the Mordor tour project. Based on these estimates, should Sam recommend accepting or rejecting this project?

• Expected annual sales in year 1 are 235 tours. Sales are expected to increase at a rate of 15% a year through year 4, at which point sales will decrease at a rate of 10% a year through year 6.
• No side effects (e.g. sales cannibalization) are expected to occur.
• The expected sales price is $3,200 per tour in year 1. Due to inflation expectations, the sales price is expected to increase by 2.5% a year.
• The expected investment in fixed assets (at time 0) is $2,000,000 and classifies as 7-years MACRS. The MACRS rates are provided at the end of this problem.
• Annual fixed costs are $78,000 in year 1. Fixed costs are expected to increase by 2.5% a year.
• Variable costs are estimated to be $1,350 per unit in year 1. Variable costs are expected to increase by 2.5% a year.
• The tax rate for Fellowship is 34%.
• The required investment in net working capital is 15% of the next year’s sales.
• The expected life of the project is 6 years at which point the asset can probably be sold for $115,000
• The firm’s discount rate is 12%.

Year	1	2	3	4	5	6	7	8
Rate	14.29%	24.49%	17.49%	12.49%	8.93%	8.92%	8.93%	4.46 %

Answer 1

Year	1	2	3	4	5	6
Annual sales = sales in previous year*(1+growth rate)	235	270.25	310.7875	357.405625	321.6650625	289.4985563
expected selling price =previous year price*(1+inflation rate)	3200	3280	3362	3446.05	3532.20125	3620.506281
annual fixed cost = previous year cost*(1+rate)	78000	79950	81948.75	83997.46875	86097.40547	88249.84061
variable cost per unit =previous year variable cost*(1+r)	1350	1383.75	1383.75	1383.75	1383.75	1383.75
Year	1	2	3	4	5	6
Cost of machine	2000000	2000000	2000000	2000000	2000000	2000000
MACRS rate	14.29%	24.49%	17.49%	12.49%	8.93%	8.92%
Annual depreciation	285800	489800	349800	249800	178600	178400
accumulated depreciation	1732200
Book value at the end of year of 6	2000000-1732200	267800
loss on sale of machine	115000-267800	-152800
tax credit on loss on sale of machine	152800*34%	51952
sale proceeds with tax credit on loss on sale of machine	115000+51952	166952
Year	0	1	2	3	4	5	6
Annual sales = annual sales*expected selling price		752000	886420	1044867.575	1231637.654	1136185.736	1048131.341
working capital requirement = 15% of next year sales	-112800	-132963	-156730.1363	-184745.6481	-170427.8604	-157219.7012	0
investment in working capital	-112800	-20163	-23767.13625	-28015.51185	14317.78773	13208.15918	157219.7012
Year	0	1	2	3	4	5	6
Annual sales = annual sales*expected selling price		752000	886420	1044867.575	1231637.654	1136185.736	1048131.341
variable cost =number of torus*variable cost per tour		317250	373958.4375	430052.2031	494560.0336	445104.0302	400593.6272
annual fixed cost = previous year cost*(1+rate)		78000	79950	81948.75	83997.46875	86097.40547	88249.84061
depreciation		285800	489800	349800	249800	178600	178400
operating profit		70950	-57288.4375	183066.6219	403280.1517	426384.3001	380887.8735
less taxes-34%		24123	-19478.06875	62242.65144	137115.2516	144970.662	129501.877
after tax profit		46827	-37810.36875	120823.9704	266164.9001	281413.6381	251385.9965
add depreciation		285800	489800	349800	249800	178600	178400
add sale proceeds with tax credit on loss on sale of machine							166952
investment in working capital	-112800	-20163	-23767.13625	-28015.51185	14317.78773	13208.15918	157219.7012
cost of machine	-2000000
net operating cash flow	-2112800	312464	428222.495	442608.4586	530282.6878	473221.7973	753957.6977
present value factor at 12% = 1/(1+r)^n r= 12%	1	0.892857143	0.797193878	0.711780248	0.635518078	0.567426856	0.506631121
present value of net operating cash flow	-2112800	278985.7143	341376.3512	315039.9583	337004.2348	268518.7565	381978.4337
NPV= sum of present value of cash flow	-189896.5512
no project should not be accepted as NPV is negative