Question

8.      You are considering a new product launch. The project will cost $680,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 100 units per year, price per unit will be $19,000, variable cost per unit will be $14,000, and fixed costs will be $150,000 per year. The required return on the project is 15%, and the relevant tax rate is 35%. Ignore the half-year rule for accounting for depreciation.          (18 marks total)

a. Calculate the following six numbers for this project. Round your answers to two decimal places.

(i) NPV                                                                              

(ii) Profitability Index (PI)                                                       (1 mark)

(iii) Payback period (in years)                                                 (1 mark)

(iv) Discounted payback period (in years)                                 (1 mark)

(v) Internal Rate of Return (IRR in %)                                      (1 mark)

(vi) Average Accounting Return (AAR in %)                             

     Hint: Net Income = {[(Price – variable cost)*Quantity Sold] – Fixed Costs – Depreciation} * (1 – Tax rate)

b. Evaluate the sensitivity of the NPV, PI, Payback period, Discounted payback period, AAR, and IRR to a ±10% variation in the number of units sold per year. Ensure that you interpret your answers in words.

Hint #1: For example, for the NPV, increase the quantity sold by 10% and re-calculate the NPV. Then calculate the percentage change of this new NPV over the base case NPV from part (a). Repeat the process for a 10% decrease in quantity sold.

Hint #2: You must perform the process in Hint #1 for each of the six items in part (a). Note that IRR and AAR are already rates of returns. You do not have to calculate the percentage changes over the base case numbers for IRR and AAR. Instead, simply calculate the difference between the new numbers and the base case numbers for IRR and AAR.

Hint #3: It may be easier to perform these calculations in a spreadsheet. If you opt to do these calculations in a spreadsheet, ensure that you copy and paste the spreadsheet into your Word document.      

Answer 1