We are considering the introduction of a new product. Currently we are in the 34

Question

We are considering the introduction of a new product. Currently we are in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the new project:

Cost of new plant and equipment $7,900,000
Shipping and installation costs $ 100,000
Unit sales

Year Units sold
1 70,000
2 120,000
3 140,000
4 80,000
5 60,000

Sales price per unit $300/unit in years 1 thru 4,
$260/unitin year 5
Variable cost per unit $180/unit
Annual fixed costs $200,000

Working capital requirements There will be an initial working-capital
requirement of $100,000 just to get
production started. For each year, the
total investment in net working capital
will be equal to 10 percent of the dollar
value of sales for that year. Thus, the
investment in working capital will
increase during years 1 through 3, then
decrease in year 4. Finally, all working
capital is liquidated at the termination of
the project at the end of year 5.
The depreciation method Use the simplified straight-line method
over 5 years. Assume that the plant and
equipment will have no salvage value
after 5 years.

a. What is the project’s initial outlay?
b. What are the differential cash flows over the project’s life?
c. What is the terminal cash flow?
d. Draw a cash flow diagram for this project.
e. What is its net present value?
f. What is its internal rate of return?

Explanation / Answer

a. Initial Outlay = $7,900,000+$100,000+$1,000,000+$100,000+$84,600,000 = $93,700,000

b. Differential Cash Flows

Year                  CF

1                   $21,000,000

2                   $36,000,000

3                   $42,000,000

4                   $24,000,000

5                   $15,600,000

c. Terminal Cash Flow = $2,100,000+$3,600,000+$4,200,000-$2,400,000 = $7,500,000

d.

e. NPV = -$93,700,000+($18,260,869.57+$27,221,172.02+$27,615,681.76+$13,722,077.89+$7,755,957.07)

    NPV = -$93,700,000+$94,575,758.31 = +$875,758.31

f. IRR = 15.35%

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