Question

At present, Solartech Skateboards is considering expanding its product line to include gas-powered skateboards; however, it is questionable how well they will be received by skateboarders. Although you feel there is a 60 percent chance you will sell 10000 of these per year for 10 years (after which time this project is expected to shut down because solar-powered skateboards will become more popular), you also recognize that there is a 20 percent chance that you will only sell 4000 and also a 20 percent chance you will sell 18000. The gas skateboards would sell for $ 140 each and have a variable cost of $30 each. Regardless of how many you sell, the annual fixed costs associated with production would be $110000. In addition, there would be an initial expenditure of $900000 associated with the purchase of new production equipment. It is assumed that this initial expenditure will be depreciated using the simplified straight-line method down to zero over 10 years. Because of the number of stores that will need inventory, the working capital requirements are the same regardless of the level of sales. This project will require a one-time initial investment of $ 30000 in net working capital, and that working-capital investment will be recovered when the project is shut down. Finally, assume that the firm's marginal tax rate is 31 percent.

a. What is the initial outlay associated with the project?

b. What are the annual free cash flows associated with the project for years 1 through 9 under each sales forecast? What are the expected annual free cash flows for years 1 through 9? (calculate separate for 10,000 , 4,000, 18,000 skateboards)

c. What is the terminal cash flow in year 10 (that is, what is the free cash flow in year 10 plus any additional cash flows associated with the termination of the project)?

d. Using the expected free cash flows, what is the project's NPV given a required rate of return of 11 percent? What would the project's NPV be if 10000 skateboards were sold?

Answer 1

Answers are as under :

a. Initial outflow is Purchase of new product equipment + working capital = ($ 900000 + $ 30000) = $ 930000

b.

Free cashflows

No. of units sold (a)	10000	4000	18000
price per unit (b)	140	140	140
variable cost (c)	30	30	30
(b-c)	110	110	110
Total Contribution	1100000	440000	1980000
Fixed cost	110000	110000	110000
Depreciation	90000	90000	90000
Profit	900000	240000	1780000
Tax @ 40%	360000	96000	712000
profit after tax	540000	144000	1068000
Addback depreciation	90000	90000	90000
Free cashflow	630000	234000	1158000