Question

3. The GreenBall Inc. is evaluating the possibility of entering the golf ball manufacturing business. Last month the company spent $20mm to rent the equipment for a small scale test run. Based on the results of the test run, the company came up with the following estimates:

• The equipment has to be purchased at the beginning of the project (year 0). The original cost of the equipment is $90mm, but the company can deduct the $20mm payment it made to the equipment supplier last month for the test run if the company decides to purchase the equipment. The original cost of the equipment, $90mm, will be depreciated straight line to zero over the project's 3-year life. The end-of-life salvage value is projected to be $10mm.

• The planned factory site is currently rented out to a neighboring company. If the company decides to enter the golf ball manufacturing business, it will lose $20mm in after-tax rental income every year during the project's 3-year life.

• Sales of golf balls are projected to be $78.43mm, 192.23mm, and $141.35 mm, for years 1,2, and 3 respectively; operating expenses are estimated to be 50% of sales.

• The inflation rate is 2%.

• Interest expense associated with debt borrowed for funding this project is $1mm per year. The company is funded with both debt and equity. The project’s funding structure is same as the firm’s overall capital structure.

• Net working capital (NWC) needs are $5mm at the beginning of the project (year 0). Afterwards, NWC at the end of each year will be equal to 10% of sales for that year. At the end of the project (i.e. end of year 3), all NWC will be recovered.

• The company's tax rate is 20%, and cost of capital is 10%.

Calculate the project’s NPV. (Using a financial calculator and without Excel)

Answer 1

Inflation rate is 2%. Therefore real cost of capital is

1.10/1.02 = 7.84%

as per fisher's equation

Computation of NPV:

Particulars	0	1	2	3
Initial outlay	(70mm)
Sales		78.43	192.23	141.35
(-) Operating exp.		39.215	96.115	70.675
(-) Interest		1	1	1
(-)NWC	(5mm)	7.843	19.223	14.135
EBT		30.372	75.892	55.54
(+) NWC				41.201
				96.741
(-) tax @ 20%		6.074	15.178	19.348
PAT		24.298	60.714	77.393
PVF @ 7.84%	1	0.927	0.86	0.797
PVFA	(75mm)	22.524	52.214	61.682

NPV = $61.42mm

The after tax rental income it will lose every year is $20mm per year which equals $60mm in 3 years. NPV is $61.42 mm. The project therefore should be accepted.