You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ),

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 $1.44 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 $1.54 million on an aftertax basis. In four years, the land could be sold for $1.64 million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $129,000. 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 4,200, 5,100, 5,700, and 4,600 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $690 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 $445,000 per year, and variable costs are 10 percent of sales. The equipment necessary for production will cost $3.90 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $420,000. Net working capital of $129,000 will be required immediately. PUTZ has a 40 percent tax rate, and the required return on the project is 14 percent. Refer to Table 10.7. What is the NPV of the project?

Explanation / Answer

Answer: Calculation of the NPV of the project:

We will begin by calculating the aftertax salvage value of the equipment at the end of the project’s life. The aftertax salvage value is the market value of the equipment minus any taxes paid (or refunded), so the aftertax salvage value in four years will be:

Taxes on salvage value = (MV BV)T = ($420,000 0)(0.40) = $168,000

Aftertax Salvage Value = MV – Taxes on Salvage Value = $420,000 – 168,000 = $252,000

Now we need to calculate the operating cash flow each year. Using the bottom up approach to calculating operating cash flow, we find:

The company should accept the new product line.

Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Revenue 2898000 3519000 3933000 3174000 Fixed cost 445000 445000 445000 445000 Variable costs 289800 351900 393300 317400 Depreciation 1299870 1733550 577590 288990 EBT 863330 988550 2517110 2122610 Taxes 345332 395420 1006844 849044 Net income 517998 593130 1510266 1273566 OCF 1817868 2326680 2087856 1562556 Capital spending -3900000 252000 Land -1540000 1640000 NWC -129000 129000 Total cash flow -5569000 1817868 2326680 2087856 3583556 P.V.F (14%) 1 0.8772 0.76946 0.67497 0.5921 PV ($) -5569000 1594634 1790287 1409240 2121824 NPV 1346985

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