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 8,000 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 $110 each with variable costs of $35 for each one produced, while annual fixed costs associated with production $180,000. In addition, there would be a $1,400,000 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 $30,000 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 31 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 required rate of return of 12 percent?

Explanation / Answer

a.

Initial outlay associated with the project = $1400000 + $30000 = $1430000

b.

Annual free cash flows for year 1 to year 9

First we calculate Net profit before taxes = 8000(110-35) - 180000 - 140000 (Depreciation) = $280000

Net profit after taxes = $280000 - ($280000*31%) = $193200

Therefore annual free cash flow for year 1 to 9 i.e. Vash flow after tax = ($193200+$140000) = $333200 per year

c.

Foe Year 10 annual free cash flow will remain same i.e. $333200

Also in Year 10 we will recover our working capital investment i.e. additional cash flow associated with the termination of the project = $30000

Total cash flow in year 10 = (333200+30000) = $363200

d.

PV of csh outflow = $1430000

PV of cash inflow

Year 1 to 9 - $333200*5.32825 = $1775372.83

Year 10 - $363200*0.32197 = $116940.6795

Total PV of cash inflow = $1892313.50952

NPV of the project = $1892313.50952 - $1430000 = $462313.50952

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