You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ),
ID: 2775574 • Letter: Y
Question
You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago for $1.48 million in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $1,580,000 on an aftertax basis. In four years, the land could be sold for $1,680,000 after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $133,000. An excerpt of the marketing report is as follows:
The zither industry will have a rapid expansion in the next four years. With the brand name recognition that PUTZ brings to bear, we feel that the company will be able to sell 4,600, 5,500, 6,100, and 5,000 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $730 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued.
PUTZ feels that fixed costs for the project will be $465,000 per year, and variable costs are 20 percent of sales. The equipment necessary for production will cost $4.30 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $440,000. Net working capital of $133,000 will be required immediately. PUTZ has a 40 percent tax rate, and the required return on the project is 12 percent. Assume the company has other profitable projects.
Explanation / Answer
Solution:
We will begin by calculating the aftertax salvage value of the equipment at the end of the project’s life. The aftertax salvage value is the market value of the equipment minus any taxes paid (or refunded), so the aftertax salvage value in four years will be:
Taxes on salvage value = (BV – MV)tC
Taxes on salvage value = ($0 – 440,000)(.38)
Taxes on salvage value = –$167,200
Market price $440,000
Tax on sale –167,200
Aftertax salvage value $272,800
Now we need to calculate the operating cash flow each year. Note, we assume that the net working
capital cash flow occurs immediately. Using the bottom up approach to calculating operating cash flow, we find:
Depreciation as per MACRS schedule will be
1. 33.33% for first year
2. 44.45% for second year
3. 14.81% for third year
4. 7.41% for Fourth year
Year 0
Year 1
Year 2
Year 3
Year 4
Revenues
3358000
4015000
4453000
3650000
Fixed Cost
465000
465000
465000
465000
Variable cost
671600
803000
890600
730000
Depreciation
1433190
1911350
636830
318630
EBT
788210
835650
2460570
2136370
Taxes(40%)
315284
334260
984228
854548
Net Income
472926
501390
1476342
1281822
OCF(NI+Dep)
1906116
2412740
2113172
1600452
Capital spending
-4300000
272800
Land
-1580000
1680000
NWC
-133000
-133000
Net Cash Flow
-6013000
1906116
2412740
2113172
3420252
Now we can use 12% discount rate to find NPV by using this formula.
NPV = –$6013000 + $1906116 / 1.12 + $2412740 / 1.122 + $2113172 / 1.123
+ $3420252 / 1.124
NPV = $1290056.91
Year 0
Year 1
Year 2
Year 3
Year 4
Revenues
3358000
4015000
4453000
3650000
Fixed Cost
465000
465000
465000
465000
Variable cost
671600
803000
890600
730000
Depreciation
1433190
1911350
636830
318630
EBT
788210
835650
2460570
2136370
Taxes(40%)
315284
334260
984228
854548
Net Income
472926
501390
1476342
1281822
OCF(NI+Dep)
1906116
2412740
2113172
1600452
Capital spending
-4300000
272800
Land
-1580000
1680000
NWC
-133000
-133000
Net Cash Flow
-6013000
1906116
2412740
2113172
3420252
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