You are considering a new product launch. The project will cost $2,300,000, have

Question

You are considering a new product launch. The project will cost $2,300,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 160 units per year, price per unit will be $30,000, variable cost per unit will be $18,500, and fixed costs will be $610,000 per year. The required return on the project is 15 percent, and the relevant tax rate is 36 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? (Negative amount should be indicated by a minus sign. Round your NPV answers to 2 decimal places. (e.g., 32.16)) Scenario Unit Sales Base Best Worst Variable Cost Fixed Costs NPV b. Evaluate the sensitivity of your base-case NPV to changes in fixed costs. (Negative amount should be indicated by a minus sign. Round your answer to 3 decimal places. (e.g., 32.161)) c. What is the cash break-even level of output for this project (ignoring taxes)? (Round your answer to 2 decimal places. (e.g., 32.16)) Cash break-even d-1 What is the accounting break-even level of output for this project? (Round your answer to 2 decimal places. (e.g., 32.16)) Accounting break-even

Explanation / Answer

Answer:a The base-case, best-case, and worst-case values are shown below. Remember that in the best-case, unit sales increase, while fixed and variable costs decrease. In the worst case, unit sales decrease, while fixed and variable costs increase.

Using the tax shield approach, the OCF and NPV for the base case estimate is:

OCFbase= [($30,000 – 18,500)(160) – $610,000](0.64) + 0.36($2300,000/4)

OCFbase= $787200+207000=$994200

NPVbase= –$2300,000 + $994200(PVIFA15%,4)

NPVbase= $538419.49

The OCF and NPV for the worst case estimate are:

OCFworst= [($30,000 – 20,350)(144) – $671,000](0.64) + 0.36($2300,000/4)

OCFworst= $459904+207000=$666904

NPVworst= –$2300,000 + $666904(PVIFA15%,4)

NPVworst= –$396,003.51

And the OCF and NPV for the best case estimate are:

OCFbest= [($30,000 – 16650)(176) – $549000](0.64) + 0.36($2300,000/4)

OCFbest= $1152384+207000=1359384

NPVbest= –$2300,000 + $1359384(PVIFA15%,4)

NPVbest= $1,581011.91

Answer:b To calculate the sensitivity of the NPV to changes in fixed costs, we choose another level of fixed costs. We will use fixed costs of $620,000. The OCF using this level of fixed costs and the other base-case values with the tax shield approach, we get:

OCF = [($30,000 – 18,500)(160) – $620,000](0.64) + 0.36($2300,000/4)

OCF = $780,800+207000=987800

And the NPV is:

NPV = –$2300,000 + $987800(PVIFA15%,4)

NPV = $520147.63

The sensitivity of NPV to changes in fixed costs is:

NPV/FC = ( $538419.49 – $520147.63)/($610,000 – 620,000)

NPV/FC = –$1.827

For every dollar FC increase, NPV falls by $1.827.

Answer:c Cash breakeven level of output:

Answer:d-1

Answer:d-2

Scenario Unit sales Variable cost Fixed costs Base 160 18500 610000 Best 176 16650 549000 Worst 144 20350 671000

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