You are considering a new product launch. The project will cost $1,700,000, have

Question

You are considering a new product launch. The project will cost $1,700,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 140 units per year; price per unit will be $22,000, variable cost per unit will be $12,500, and fixed costs will be $490,000 per year. The required return on the project is 10 percent, and the relevant tax rate is 32 percent. a. Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within ±10 percent. What are the upper and lower bounds for these projections? What is the base-case NPV? What are the best-case and worst-case scenarios?

B. Evaluate the sensitivity of your base-case NPV to changes in fixed costs.

C. What is the cash break-even level of output for this project (ignoring taxes)?

D1. What is the accounting break-even level of output for this project?

D2. What is the degree of operating leverage at the accounting break-even point?

B. Evaluate the sensitivity of your base-case NPV to changes in fixed costs.

C. What is the cash break-even level of output for this project (ignoring taxes)?

D1. What is the accounting break-even level of output for this project?

D2. What is the degree of operating leverage at the accounting break-even point?

Explanation / Answer

Base case Time line 0 1 2 3 4 Project cost -1700000 +Increase in working capital 0 =Initial Investment outlay -1700000 Sales No. of units*(selling price - variable cost) 1330000 1330000 1330000 1330000 -Fixed cost -490000 -490000 -490000 -490000 -Depreciation (cost of equipment and plant)/4 -425000 -425000 -425000 -425000 = 415000 415000 415000 415000 -taxes =(net sales - fixed cost - depreciation)*(1-tax) 282200 282200 282200 282200 +Depreciation 425000 425000 425000 425000 =after tax operating cash flow 707200 707200 707200 707200 Reversal of Increase in working capital 0 = Terminal year after tax non operating CF 0 Total Cash flow -1700000 707200 707200 707200 707200 Cost of capital = 10% Discount factor = (1 + cost of capital) ^ corresponding period 1 1.1 1.21 1.331 1.4641 Discounted cashflow = total cash flow/discount factor -1700000 642909.1 584462.8 531329.8 483027.1 NPV= Sum of discounted cash flow = 541728.844 Best case Time line 0 1 2 3 4 Project cost -1700000 +Increase in working capital 0 =Initial Investment outlay -1700000 Sales 1.1*No. of units*(1.1*selling price - variable cost*.9) 1994300 1994300 1994300 1994300 -Fixed cost =.9* base case fixed cost -441000 -441000 -441000 -441000 -Depreciation (cost of equipment and plant)/4 -425000 -425000 -425000 -425000 = 1128300 1128300 1128300 1128300 -taxes =(net sales - fixed cost - depreciation)*(1-tax) 767244 767244 767244 767244 +Depreciation 425000 425000 425000 425000 =after tax operating cash flow 1192244 1192244 1192244 1192244 Reversal of Increase in working capital 0 = Terminal year after tax non operating CF 0 Total Cash flow -1700000 1192244 1192244 1192244 1192244 Cost of capital = 10% Discount factor = (1 + cost of capital) ^ corresponding period 1 1.1 1.21 1.331 1.4641 Discounted cashflow = total cash flow/discount factor -1700000 1083858 985325.6 895750.6 814318.7 NPV= Sum of discounted cash flow = 2079253.06 Worst case Time line 0 1 2 3 4 Project cost -1700000 +Increase in working capital 0 =Initial Investment outlay -1700000 Sales 0.9*No. of units*(0.9*selling price - variable cost*1.1) 762300 762300 762300 762300 -Fixed cost =1.1* base case fixed cost -539000 -539000 -539000 -539000 -Depreciation (cost of equipment and plant)/4 -425000 -425000 -425000 -425000 = -201700 -201700 -201700 -201700 -taxes =(net sales - fixed cost - depreciation)*(1-tax) -137156 -137156 -137156 -137156 +Depreciation 425000 425000 425000 425000 =after tax operating cash flow 287844 287844 287844 287844 Reversal of Increase in working capital 0 = Terminal year after tax non operating CF 0 Total Cash flow -1700000 287844 287844 287844 287844 Cost of capital = 10% Discount factor = (1 + cost of capital) ^ corresponding period 1 1.1 1.21 1.331 1.4641 Discounted cashflow = total cash flow/discount factor -1700000 261676.4 237887.6 216261.5 196601.3 NPV= Sum of discounted cash flow = -787573.25

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