Question

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 $2.9 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 $3.1 million on an aftertax basis. In four years, the land could be sold for $3.3 million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $375,000. 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 7,100, 7,800, 8,400, and 6,700 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $525 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued.

PUTZ believes that fixed costs for the project will be $755,000 per year, and variable costs are 15 percent of sales. The equipment necessary for production will cost $3.65 million and qualifies for 100 percent bonus depreciation in the first year. At the end of the project, the equipment can be scrapped for $615,000. Net working capital of $325,000 will be required immediately. PUTZ has a tax rate of 25 percent, and the required return on the project is 13 percent.

What is the NPV of the project?

Answer 1

NPV = -1,304,596.34. The company should reject the project as it has a negative NPV.

Formula Spending on equipment 3750000 Q*p 15%*S 7100 525 3727500 5591251 755000 3650000 -1236625 -309156.25 -927468.75 7800 525 4095000 614250 7550001 8400 525 4410000 661500 755000 67001 525 3517500 527625 755000 Year (n) Initial investment (11) Quantity (0) Price per unit (p) Sales (S) Variable cost (VC) Fixed cost (FC) Depreciation (D) EBIT Tax @ 25% Unlevered net income (NI) Add: Depreciation (D) Operating Cash Flow (OCF) Increase in NWC After-tax salvage value (SV) Land opportunity cost (OC) Free Cash Flow (FCF) Discount factor @ 13% PV of FCF NPV 100% bonus depreciation S-VC-FC-D 25%*EBIT EBIT-Tax 2725750 681437.5 2044312.5 2993500 748375 2245125 2234875 558718.75 1676156.25 -927468.75 2044312.5 NI+D Recovery of NWC in year 4 Salvage value*(1-Tax rate) -325000 2245125 1676156.25 325000 4612501 3300000 2245125 5762406.25 0.693 0.613 1555984.25 3534191.67 -3100000 -7175000 1.000 -7175000 -1304596.34 OCF-Inc.in NWC + SV - OC - || 1/(1+13%)^n FCF*Discount factor Sum of all PVS -927468.75 0.885 -820768.81 2044312.5 0.783 1600996.55

The after-tax selling price of land is an opportunity cost which has to be included in the calculations.