You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ),

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 $1.8 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 $2.1 million on an aftertax basis. The company also hired a marketing firm to analyze the zither market, at a cost of $275,000.

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 22,500, 29,300, 34,000, and 23,200 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $175 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 $850,000 per year, and variable costs are 15 percent of sales. The equipment necessary for production will cost $5.3 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $500,000. Net working capital of $450,000 will be required immediately and will be recaptured at the end of the project. PUTZ has a 38 percent tax rate, and the required return on the project is 13 percent.

MACRS Depreciation Schedule

Year 1: 33.33%

Year 2: 44.45%

Year 3: 14.81%

Year 4: 7.41%

1. What is the NPV of the project?

2. IRR

3.Discounted Payback

4.Profitability Index

Explanation / Answer

Table of Cash flows is presented below:

Wroking notes:

1) Initial investment

2) Terminal value

1) NPV of the project =$42,79,940

2) IRR = 61%

3) Discount payback period

Discounted payback period = 1.7 years

4) PI = 7929940/3650000

= 2.17

Year 0 1 2 3 4 Sale units 22500 29300 34000 23200 Selling price $175 $175 $175 $175 Sales revenue $39,37,500 $51,27,500 $59,50,000 $40,60,000 variable costs $5,90,625 $7,69,125 $8,92,500 $6,09,000 Fixed cost $8,50,000 $8,50,000 $8,50,000 $8,50,000 Depreciation $17,66,490 $23,55,850 $7,84,930 $3,92,730 Operating income $7,30,385 $11,52,525 $34,22,570 $22,08,270 Tax @38% $2,77,546 $4,37,960 $13,00,577 $8,39,143 Income after tax $4,52,839 $7,14,566 $21,21,993 $13,69,127 Cash flow from operations $22,19,329 $30,70,416 $29,06,923 $17,61,857 Initial investment -$36,50,000 Terminal value $7,60,000 Net cash flows -$36,50,000 $22,19,329 $30,70,416 $29,06,923 $25,21,857 cost of capital $1 $0.885 $0.783 $0.693 $0.613 Present value of cash flows -$36,50,000 $19,64,008 $24,04,586 $20,14,644 $15,46,702

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