You are considering expanding your product line that currently consists of skate

Question

You are considering expanding your product line that currently consists of skateboards to include gas-powered skateboards, and you feel
you can sell 10,000 of these per year for 10 years (after which time this project is expected to shut down with solar-powered
skateboards taking over). The gas skateboards would sell for $100 each with variable costs of $40 for each one produced,
while annual fixed costs associated with production $160,000. In addition, there would be a $1,000,000 initial expenditure associated
with the purchase of new production equipment. It is assumed that this initial expenditure will be depreciated using the simplified
straight-line method down to zero over 10 years. This project wil also require a one-time initial investment of $50,000 in net
working capital associated with inventory and that working capital investment will be recovered when the project is shut down.
Finally, assume that the firm's marginal tax rate is 34 percent.

a. What is the initial outlay associated with this project?
b. What are the annual free cash flows associated with this project for years 1 through 9?
c. What is the terminal cash flow in year 10 (that is, what is the free cash flow in year 10 plus and additional cash flows
associated with termination of the project?
d. What is the project's NPV given a 10 percent required rate of return?

Explanation / Answer

a. The initial outlay includes the cost of the new machine as well as the investment in working capital here:
(NNN) NNN-NNNN+ 50000 =
1,050,000


b. Earnings before interest/taxes:

EBIT = 10000*(100-40) (sales - variable costs) - 160000 (fixed costs) - 100000 (depreciation)

EBIT = 600000 - 160000 - 100000 = 340000

After taxes, this results in net income = 340000(1-0.34) = 224400

Add back depreciation to this to find the annual free cash flow:

Annual free cash flows for years 1 through 9 = 224400 + 100000 = 324,400

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