You are evaluating a project for The Ultimate recreational tennis racket, guaran

Question

You are evaluating a project for The Ultimate recreational tennis racket, guaranteed to correct that wimpy backhand. You estimate the sales price of The Ultimate to be $400 and sales volume to be 1,000 units in year 1, 1,250 units in year 2, and 1,325 units in year 3. The project has a 3 year life. Variable costs amount to $225 per unit and fixed costs are $100,000 per year. The project requires an initial investment in equipment of $165,000 which is depreciated straight-line to zero over the 3 year project life. The actual market value of the equipment at the end of year 3 is $35,000. Initial net working capital investment is $75,000 and NWC will maintain a level equal to 20% of sales each year thereafter. The tax rate is 35% and the required return on the project is 10%.

PLEASE SHOW WORK

c. What amount of project NPV is due to the sale of the equipment in year 3?

Explanation / Answer

Notes:

In above calculation variable cost = no. of units sold * variable cost per unit

Depreciation per period = 165000/3 = 55000

Change in NWC = NWC current year - NWC previous year.

NWC current year for all years except for year 0 = 20 percent of sales

Change in NWC for year 3 = $100,000 because all previous NWC has to be reversed since the project has ended and there is no need to maintain any working capital

PV of 1) cash flow year 1 = 63000/(1 + 10/100) = $ 57,272.27

2) cash flow year 2 = 73837.5/(1 + 10/100)^2 = $ 61022.72

3) cash flow year 3 = 239968.8/(1 + 10/100)^3 = $ 180,292.11

NPV = Sum of PV of cash inflows - initial investment outlay

= 57,272.27 + 61022.72 + 180,292.11 - 240000

= $ 58,587.1

NPV due to year 3 = NPV * (PV of year 3 cash inflow)/(Total cash inflow)

= 58,587.1 * (180,292.11)/(57,272.27 + 61022.72 + 180,292.11)

=$ 35,375.91

Year 0 1 2 3 Sales 0 400000 500000 530000 - Variable cost 0 -225000 -285250 -298125 - Fixed cost 0 -100000 -100000 -100000 - Depreciation 0 -55000 -55000 -55000 = EBIT 0 20000 59750 76875 - Taxes 0 7000 20912.5 26906.25 = Net income 0 13000 38837.5 49968.75 + Depreciation 0 55000 55000 55000 = Operating cash flow 0 68000 93837.5 104968.8 - Change in NWC -75000 -5000 -20000 100000 - Change in Fixed Asset -165000 0 0 35000 = Total cash flow -240000 63000 73837.5 239968.8

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