Question

Your company has just completed a $0.85 million marketing survey that found that your new product is going to be a big hit. Producing the game will require an immediate (year 0) $0.9 million capital investment. Net working capital will have to increase in year 0 from $0.5 million to $1million, and will return to the original 0.5 million level at the end of the project. You expect annual revenues of $5 million in years 1 through 3. The variable and fixed costs will equal 70% of annual sales. You also project that 25% of those revenues will come from your existing customers switching from your old game, which also has costs equal to 70% of sales. The new equipment will be depreciated over 3 years to a book value of 0 using the straight-line method. You have contracted to sell the equipment for $0.4 million at the end of the third (3rd) year, at which point production will end. Your discount rate is 12% and your tax rate is 25%. Show the relevant cash flows for this project in years 0 through 3 and compute its NPV. Should you produce new game? Why yes or why not?

Year 0 Year 1 Year 2 Year 3

(Free) Cash Flow from

Assets

NPV=

Answer 1

Game	0	1	2	3
Investment	-900,000
Salvage				400,000
NWC	-500,000			500,000
Sales		5,000,000	5,000,000	5,000,000
Costs		-3,500,000	-3,500,000	-3,500,000
Depreciation		-300,000	-300,000	-300,000
Lost Sales		-375,000	-375,000	-375,000
EBT		825,000	825,000	825,000
Tax (25%)		-206,250	-206,250	-206,250
Net Income		618,750	618,750	618,750
Cash Flows	-1,400,000	918,750	918,750	1,718,750
NPV	$1,376,107

Depreciation = Investment / 3 = 300,000

Lost Sales = 5,000,000 x 25% x (1 - 70%) = 375,000

Cash Flows = Investment + NWC + Salvage x (1 - tax) + Net Income + Depreciation

NPV can be calculated using the same function in excel or calculator with 12% discount rate.

As NPV > 0, the project should be accepted.