You are considering a new product launch. The project will cost $857,000, have a
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Question
You are considering a new product launch. The project will cost $857,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 180 units per year; price per unit will be $19,200, variable cost per unit will be $15,100, and fixed costs will be $345,000 per year. The required return on the project is 11 percent, and the relevant tax rate is 34 percent.
Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within ±5 percent.
What are the best and worst case NPVs with these projections? (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places (e.g., 32.16).)
What is the sensitivity of the NPV to changes in fixed costs? (Do not round intermediate calculations. Input the amount as a positive value. Round your answer to 2 decimal places (e.g., 32.16).)
You are considering a new product launch. The project will cost $857,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 180 units per year; price per unit will be $19,200, variable cost per unit will be $15,100, and fixed costs will be $345,000 per year. The required return on the project is 11 percent, and the relevant tax rate is 34 percent.
Explanation / Answer
In case of best case scenario, units sales will increase with a decrease in variable cost and fixed cost. In case of worst case scenario, units sales will decrease and variable and fixed cost will increase. The following table highlights the best and worse case scenarios:
Part A)
To calculate the NPV, we will have to determine the operating cash flow under each scenario with the use of following formula:
Operating Cash Flow = [Units*(Selling Price - Variable Cost) - Fixed Cost]*(1-Tax Rate) + Tax Rate*(Depreciation) where Depreciation = Cost/Estimated Life
Using the table above, we get,
Operating Cash Flow (Best Case Scenario) = [189*(19,200 - 14,345) - 327,750]*(1-34%) + 34%*(857,000/4) = $462,142.70
Operating Cash Flow (Worst Case Scenario) = [171*(19,200 - 15,855) - 362,250]*(1-34%) + 34%*(857,000/4) = $211,276.70
Now, we can calculate the NPV with the use of following formula:
NPV = -Initial Investment + Operating Cash Flow Year 1/(1+Required Return)^1 + Operating Cash Flow Year 2/(1+Required Return)^2 + Operating Cash Flow Year 3/(1+Required Return)^3 + Operating Cash Flow Year 4/(1+Required Return)^4
Using the values calculated above, we get,
NPV (Best Case Scenario) = - 857,000 + 462,142.70/(1+11%)^1 + 462,142.70/(1+11%)^2 + 462,142.70/(1+11%)^3 + 462,142.70/(1+11%)^4 = $576,772.63
_______
NPV (Worst Case Scenario) = - 857,000 + 211,276.70/(1+11%)^1 + 211,276.70/(1+11%)^2 + 211,276.70/(1+11%)^3 + 211,276.70/(1+11%)^4 = -$201,525.52
__________
Part B)
To calculate the base case NPV, we need to calculate the operating cash flow as follows:
Operating Cash Flow (Base Case) = [180*(19,200 - 15,100) - 345,000]*(1-34%) + 34%*(857,000/4) = $332,225
Now, we can calculate NPV as follows:
NPV (Base Case) = -857,000 + 332,225/(1+11%)^1 + 332,225/(1+11%)^2 + 332,225/(1+11%)^3 + 332,225/(1+11%)^4 = $173,710.02
__________
Part C)
To determine the sensitivity, we will have to calculate operating cash flow and NPV for another level of fixed cost. Let us assume that the fixed cost is $355,000. Now, the revised operating cash flow and NPV are calculated as follows:
Operating Cash Flow (Revised Fixed Cost) = [180*(19,200 - 15,100) - 355,000]*(1-34%) + 34%*(857,000/4) = $325,625
NPV (Revised Fixed Cost) = -857,000 + 325,625/(1+11%)^1 + 325,625/(1+11%)^2 + 325,625/(1+11%)^3 + 325,625/(1+11%)^4 = $153,233.88
Now, we can determine the sensitivity of the NPV to changes in fixed costs as follows:
Sensitivity = Change in NPV/Change in Fixed Costs = (153,233.88 - 173,710.02)/(355,000 - 345,000) = -2.05
For every dollar FC increase, NPV falls by $2.05.
Scenario Unit Sales Variable Cost Fixed Cost Current (Base) 180 15,100 345,000 Best 189 [(180*(1+5%)] 14,345 [15,100*(1-5%)] 327,750 [345,000*(1-5%)] Worse 171 [(180*(1-5%)] 15,855 [(15,100*(1+5%)] 362,250 [(345,000*(1+5%)]Related Questions
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