Question

The Scenario:

You work in the product development department of an athletic apparel company. Your company has decided to add a new product and is choosing between a polo tee, yoga pants, or running shoes.

You have been asked to evaluate the financial profitability of each option. You have estimated that the company has $1,500,000 to invest in the project, and each product has the potential to bring in an estimated $2,000,000 of future cash flows, although the timing of the cash flows varies per product.

Additionally, two of the products would use equipment that could be sold at the end of the project cycle. In order to pay for the project, the company will have to finance at a 6% interest rate. Present value discount factors are listed as follows:

Years ܝ ܢܕ ܚ PV of 1 at 6% 0.94340 0.89000 0.83962 0.79209 0.74726 PV of an Annuity at 6% 0.94340 1.83339 2.67301 3.46511 4.21236 ܛ ܗ

Formulas:Requirements

1. Calculate the profitability of each project using the following methods. Show your work.

• The payback method

• Net present value (NPV)

2. Make a decision on which product to produce by answering the Pause and Reflect questions at the end.

Option 1: Polo Shirts

   

1. Calculate the payback period of polo shirts. In other words, how many years will it take for the company to recoup the initial investment?

It will take the company 3.75 years.

2. Calculate the NPV of polo shirts. In other words, when comparing apples to apples (the present value of cash inflows to the present value of cash outflows), what will the expected profit of the project be?

The expected profit will be $500,000.

Option 2: Yoga Pants

3. Calculate the payback period of yoga pants. Because the equipment will be sold in the 4th year, the cash flows for each year will not be the same (they are the same for years 1-3, but not for year 4). Use the following setup to calculate the payback period for a project with unequal cash flows:

Year	Annual Net Cash Flow	Cumulative Net Cash Flows
1	$500,000	$500,000
2	$5,000,000	$10,000,000
3	$5,000,000	$1,500,000
4	$550,000	$2,050,000

4. Calculate the NPV of yoga pants.

a) Notice that for all four years the company will receive the same cash flow provided by the product. Use the PV of an annuity discount factor for this part of the calculation.

b) Notice also that the company will sell equipment in the 4th year for an additional cash flow. Which present value table should you use when calculating a single sum? Add this amount to the PV found in part a) to determine the PV of total net cash flows.

Option 3: Running Shoes

5. Calculate the payback period of running shoes.

Year	Annual Net Cash Flow	Cumulative Net Cash Flows
1
2
3
4

6. Calculate the NPV of running shoes.

a) Notice that every year the company will receive a different cash flow. In order to calculate the PV of the total net cash flows, you will need to take the individual PV of each future cash flow and add them together.

Answer 1

1	Payback Calculation of Polo Shirts
	Investment	(1,500,000)
	Year	Cash Flows	Balance
	1	400,000	(1,100,000)
	2	400,000	(700,000)
	3	400,000	(300,000)
	4	400,000	100,000
	5	400,000	500,000
	3 Years + (300000/400000) =		3.75 Years
	NPV	500,000
	Total Future Cash Flows		2,000,000
	Initial Costs		1,500,000
	NPV= Total Future Cash Flows - Initial Investments
	Payback Calculation of Yoga Pants
	Investment	(1,500,000)
	Year	Cash Flows	Balance
	1	500,000	(1,000,000)
	2	500,000	(500,000)
	3	500,000	-
	4	550,000	550,000
			3 Years
	NPV	550,000
	Total Future Cash Flows		2,050,000
	Initial Costs		1,500,000
	NPV= Total Future Cash Flows - Initial Investments
	Payback Calculation of Running Shoes
	Investment	(1,500,000)
	Year	Cash Flows	Balance
	1	300,000	(1,200,000)
	2	600,000	(600,000)
	3	750,000	150,000
	4	400,000	550,000
	2 Years + (600000/750000) =		2.8 years
	NPV	550,000
	Total Future Cash Flows		2,050,000
	Initial Costs		1,500,000
	NPV= Total Future Cash Flows - Initial Investments

2

2.1.	3.75 years to recoup the initial investments
2.2.	The expected profit of US$500,000
2.3.	3 years to recoup the initial investments
2.4.a)	Year	Annual Net Cash Flows before Annuity Discount	Annual Net Cash Flows after Annuity Discount
	1	500,000	471,700
	2	500,000	445,000
	3	500,000	419,810
	4	500,000	396,045

2.4. b)	Year	Annual Net Cash Flows before Annuity Discount	Annual Net Cash Flows after Annuity Discount
	1	500,000	471,700
	2	500,000	445,000
	3	500,000	419,810
	4	550,000	435,650

2.5	Payback Calculation of Running Shoes
	Investment	(1,500,000)
	Year	Cash Flows	Balance
	1	300,000	(1,200,000)
	2	600,000	(600,000)
	3	750,000	150,000
	4	400,000	550,000
	2 Years + (600000/750000) =		2.8 years
	Year	Annual Net Cash Flow	Cumulative Net Cash Flows
	1	300,000	300,000
	2	600,000	900,000
	3	750,000	1,650,000
	4	400,000	2,050,000

2.6.	NPV	550,000
	Total Future Cash Flows		2,050,000
	Initial Costs		1,500,000
	NPV= Total Future Cash Flows - Initial Investments
2.6.a)	Year 1
	NPV	(1,200,000)
	Annual Cash Flows		300,000
	Initial cost		1,500,000
	Year 2
	NPV	(600,000)
	Annual Cash Flows		600,000
	Initial cost		1,200,000
	Year 3
	NPV	150,000
	Annual Cash Flows		750,000
	Initial cost		600,000
	Year 4
	NPV	550,000
	Annual Cash Flows		400,000
	Initial cost		(150,000)