Assignment
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 3,600, 4,300, 5,200, and 3,900 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $750 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 believes that fixed costs for the project will be $415,000 per year, and variable costs are 15 percent of sales. The equipment necessary for production will cost $3.5 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $350,000. Net working capital of $125,000 will be required immediately. PUTZ has a 38 percent tax rate, and the required return on the project is 13 percent. What is the NPV of the project?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 $2.1 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 $2.3 million on an aftertax basis. In four years, the land could be sold for $2.4 million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $125,000. 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 3,600, 4,300, 5,200, and 3,900 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $750 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 believes that fixed costs for the project will be $415,000 per year, and variable costs are 15 percent of sales. The equipment necessary for production will cost $3.5 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $350,000. Net working capital of $125,000 will be required immediately. PUTZ has a 38 percent tax rate, and the required return on the project is 13 percent. What is the NPV of the project?
| Year | Investment A | Investment B |
| 0 | -$5,000,000 | -5,000,000 |
| 1 | $1,500,000 | $1,250,000 |
| 2 | $1,500,000 | $1,250,000 |
| 3 | $1,500,000 | $1,250,000 |
| 4 | $1,500,000 | $1,250,000 |
| 5 | $1,500,000 | $1,250,000 |
| 6 | $1,500,000 | $1,250,000 |
| 7 | $2,000,000 | $1,250,000 |
| 8 | 0 | $1,600,000 |
Introduction/Background
Pristine Urban-Tech Zither, Inc. has hired a consultant. This company PUTZ is dealing in manufacturing of fine zithers. The company needs to assess the market for zither manufacturing, which is rising rapidly. The company has recently bought some property, land at the cost of $2.1 million about three years ago for using it for a dump for toxic waste. However, the company PUTZ has hired another company for the handling of all the toxic materials. The company has used a recent appraisal for the assumption of selling off the land for $2.3 million on an after-tax basis. In the next four years, the land can be sold for $2.4 million after taxes. The hired marketing firm, which was hired at the cost of $125,000 for the analysis of the zither market, and the potential opportunities that it may offer to the PUTZ Company put forward their analysis report.
This report showed that the zither company is going to undergo rapid expansion in the next four years. As per its prediction, the company would be able to make the following sales of its zither units:
| 1 | 2 | 3 | 4 | |
| Sales (units) | 3,600 | 4,300 | 5,200 | 3,900 |
The analysis showed that the brand recognition of the name PUTZ would aid it in selling the zither units at a premium price of $750. However, the sales should be discontinued after four years of manufacturing. The various costs, which PUTZ believes it would have to incur, include;
Fixed cost at a rate of $145,000 per year and the variable costs at the rate of 15% of sales. The company would need equipment for manufacturing that would cost $3.5 million. The marketing firm has advised on using the MACRs schedule for the computation of depreciation expense. The marketing firm has shown that the equipment can be scrapped for an amount of $350,000. Other than this, the amount of net working capital is assumed$125, 000, which would be required immediately. The company PUTZ has a tax rate of 38%, and the required rate of return for this project is 13%.
Problem
The zither industry is going into an expansion period, and the company needs to assess the market for zither manufacturing, which is rising rapidly. The company has recently purchased some property, land at the cost of $2.1 million about three years ago for using it for a dump for toxic waste. However, the company PUTZ has hired another company for the handling of all the toxic materials. Now it needs to assess what it should do with the land and whether it should continue the sales or discontinue the operations for zither units. For this purpose, it is needed that the company should use a valuation technique for the value of this project. Net Present Value is one of the tools in which the company needs to calculate its cash inflows and cash outflows (Jain & Khan, 2007). By computing its present value and comparing them with each other, the company PUTZ would be able to get the solution to the problem by knowing if the project is feasible to continue or not. The positive Net present value would show that the manufacturing and sales of the zither units along with the sale of the land bought three years ahead after four years of operation would be enough to cover all the costs and give profit as well. However, the negative net present value would depict that it would not be enough to cover the costs and hence would not be feasible to continue.
Solution
For the computation of Net Present Value of this project, we will use the following formula:
Net Present Value= ∑(Present Value of Future Cash FLows)/(1+Required Rate of Return)
For the solution, the data is gathered in tabular form:
| Cost of Equipment | 3,500,000.00 |
| Working Capital | 125,000.00 |
| Equipment Scrap Value | 350,000.00 |
| tax rate | 0.38 |
| Required Rate of Return | 0.13 |
| 1,000,000.00 | |
| Land Purchases 3 years before | 2,100,000.00 |
| After tax Selling value | 2,300,000.00 |
| In four Years Selling value after tax | 2,400,000.00 |
| Cost of marketing firm | 125,000.00 |
| Premium Price | 750.00 |
| Fixed Cost | 415,000.00 |
| Variable Cost | 0.15 |
Firstly, the initial cost or the initial expenditure will be calculated:
The initial cost is calculated by this formula:
Initial Cost=Cost of Equipment+Working Capital
| Initial Cost: | |
| Add: | |
| Equipment Cost | 3,500,000.00 |
| Working Capital | 125,000.00 |
| Initial Cost: | 3,625,000.00 |
The depreciation Expense is computed by using the MACRS schedule (Murphy & Higgins, 2010) for three years:
| Comp. of Depreciation Expense: | ||||
| 1 | 2 | 3 | 4 | |
| MACRS Schedule | 33.33% | 44.45% | 14.81% | 7.41% |
| Depreciation Exp. | 1,166,550 | 1,555,750 | 518,350 | 259,350 |
Next is the step to compute the Operating Cash Flows for this project:
| Comp. of Operating Cash Flows | ||||
| 1 | 2 | 3 | 4 | |
| Sales (units) | 3,600 | 4,300 | 5,200 | 3,900 |
| Sales | 2,700,000 | 3,225,000 | 3,900,000 | 2,925,000 |
| Fixed Costs | 415,000 | 415,000 | 415,000 | 415,000 |
| 2,285,000 | 2,810,000 | 3,485,000 | 2,510,000 | |
| Variable Costs | 405,000 | 483,750 | 585,000 | 438,750 |
| 1,880,000 | 2,326,250 | 2,900,000 | 2,071,250 | |
| Depreciation Exp. | 1,166,550 | 1,555,750 | 518,350 | 259,350 |
| 713,450 | 770,500 | 2,381,650 | 1,811,900 | |
| Taxes | 271,111 | 292,790 | 905,027 | 688,522 |
| 442,339 | 477,710 | 1,476,623 | 1,123,378 | |
| Net Income | (171,228) | (184,920) | (571,596) | (434,856) |
| Depreciation Exp. | 1,166,550 | 1,555,750 | 518,350 | 259,350 |
| (175,506) | ||||
| 4th-year Equipment Inflow and Dec in WC | 342,000.00 | |||
| Operating Cash Flow | 995,322 | 1,370,830 | (53,246) | 166,494 |
The above computations are being done by using this formula:
Operating Cash Flow=(Sales-Fixed cost-Variable Cost-Depriciation)×(1-tax rate)+ Depreciation Expense
Sales units are multiplied by the premium price to get the Sales Value for the four years. The fixed costs and Variable Costs are then deducted where variable cost is computed as 15% of the sales value per year. The depreciation expense, which was computed earlier, is then deducted from this value. The taxes are calculated at the rate of 38%. The net income computed from this is used to add back the depreciation amount. Another computation is done for the 4th year cash flow. The land is sold in the 4th year, and the working capital is used here. The result is the operating cash flow for each year (Heitger, Mowen, & Hansen, 2007).
Now, for the Net Present Value computation:
| NPV = | Initial Cost + PV of Future Cash flows |
| Initial Cost : | (3,625,000.00) | + | ||
| PV of Future Cash Flows: | $880,815.93 | $2,741,660.00 | ($159,738.00) | $665,976.00 |
| NPV = | $ 503,713.93 |
The Initial Cost computed is added to the present value of the operating cash flows for the four years computed above. The required rate of return of 13% is used as a discounting rate. The resulting Net present value of $503,713 shows that the manufacturing and sales of the zither units along with the sale of the land bought three years ahead after four years of operation would be enough to cover all the costs and give profit as well of $503,713 to the PUTZ Company (Murphy & Higgins, 2010).
Conclusion
The positive Net Present Value of the project shows that the manufacturing and sales of the zither units along with the sale of the land bought three years ahead after four years of operation would be enough to cover all the costs and give profit as well of $503,713 to the PUTZ Company. It is to be noted that the company PUTZ has negative cash flow in the third year; however, the resultant Net Value is positive showing the potential of profitability of this project at the discount rate of 13%.
References
Heitger, D. L., Mowen, M. M., & Hansen, D. R. (2007). Fundamental Cornerstones of Managerial Accounting. Cengage Learning.
Jain, & Khan. (2007). Financial Management. Tata McGraw-Hill Education.
Murphy, K., & Higgins, M. (2010). Concepts in Federal Taxation 2010. Cengage Learning.
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