Question

The year is 2015 and you consider producing and selling garden gnomes in the likeness of Urban Meyer. You plan for only a three-year horizon, on the off chance that he resigns as OSU head football coach. It will cost you $120,000 to purchase the machinery to produce the garden gnomes. The machinery will be depreciated straight-line to zero over three years, but you expect to be able to sell the equipment at the end of the third year for a salvage value of $20,000. Your price per gnome, variable cost per gnome, and quantity of gnomes sold are forecasted as follows:

	Year 1	Year 2	Year 3
Price	$40	$45	$50
Variable Cost	$22	$22	$22
Quantity	4000	4000	4000

Your fixed costs are $50,000 per year and your tax rate is 21%. You will also need $8,000 in initial net working capital, which will be returned to you at the end of the project.

	Time 0	Year 1	Year 2	Year 3
CapEx				ATSV =
NWC				Return of NWC =
					Net OCF
Total

A. Solve for the after-tax salvage value and annual net OCF and place those values in the proper cells in the table above, along with the CapEx and NWC numbers.

B. The WACC for this project is 10%. Solve for the NPV. Should you take this project?

Answer 1

Answer A:

First let us calculate Net OCF:

Year 1 Year 2 Year 3 $45 $40 $50 Price $22 $22 $22 Variable Cost 4000 Quantity 4000 4000 $160,000 $180,000 $200,000 (S88,000) (S88,000) (S88,000) ($50,000) (S50,000) (S50,000) ($40,000) ($40,000) ($40,000) ($18,000) $3,780 ($14,220) $40,000 $40,000$40,000 $25,780 $41,580$57,380 Sales Revenue Variable Cost Fixed Cost Depreciation $2,000 $22,000 ($420) ($4,620) $1,580 $17,380 ЕBIT Tax at 21% EAT Add Back depreciation Net OCF

The after-tax salvage value and annual net OCF are as follows:

Time 0 Year 1 Year 2 Year 3 Year ($120,000) СаpEx $15,800 NWC (S8,000) $8,000 $25,780 $41,580$57,380 ($128,000) $25,780$41,580 $81,180 Net OCF Total Cash flow

Answer B:

NPV of the Project = -$9,208.26

No,

You should not take this project. The NPV is negative.

Working:

Time 0 Year 1 Year 2 Year 3 Year ($120,000) СаpEx $15,800 NWC (S8,000) $8,000 $25,780 $41,580$57,380 Net OCF ($128,000)$25,780 $41,580 $81,180 ($9,208.26) Total Cash flow NPV at 10%