At present Solartech Skateboards is considering expanding its product line to in

Question

At present Solartech Skateboards is considering expanding its product line to include gas-powered skateboards; however, it is questionable how well they will be received by skateboarders. While you feel there is a 50 percent chance you will sell 11,000 of these per year for 10 years (after which time this project is expected to shut down because solar-powered skateboards will become more popular), you also recognize that there is a 25 percent chance that you will only sell 4,000 and also a 25 percent chance you will sell 17,000. The gas skateboards would sell for $130 each and have a variable cost of $40 each. Regardless of how many you sell, the annual fixed costs associated with production would be $130,000. In addition, there would be an initial expenditure of $1,100,000 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. Because of the number of stores that will need inventor.-, the working capital requirements are the same regardless of the level of sales, and this project will require a one-time initial investment of $40,000 in net working capital 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 the project? What are the annual free cash flows associated with the project for years 1 through 9 under each sales forecast? What are the expected annual free cash flows for years 1 through 9? What is the terminal cash flow in year 10 (that is, what is the free cash flow in year 10 plus any additional cash flows associated with the termination of the project)? Using the expected free cash flows, what is the project's NPV given a required rate of return of 9 percent? What would the project's NPV be if 11,000 skateboards were sold?

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

C- Terminal cash flow in year 10 will just be nearly the same as the annual year cash flow except they recover the 50000 initial working capital investment as the problem described so it will be:

324400+50000 = 374400

D- NPV = All the cash flows discounted

I don't have a financial calculator with me that allows me to do NPV so I used this and plugged the numbers in (-1050000 for initial cost, 324400 for the first 9 cash flows and 374400 for the last cash flow):

NPV = -1050000 + 324400/1.1 + 324400/(1.1^2) + ...+ 324400/(1.1^9) + 374400/(1.1^10) = 962574.73

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