A company is considering manufacturing new elliptical trainers. This company did a marketing research 2 years...

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A company is considering manufacturing new elliptical trainers.This company did a marketing research 2 years ago, paying $750,000consulting fees and found that the market is ripe for such a newproduct. The company feels that they can sell 5,000 of these peryear for 5 years (after which time this project is expected to shutdown). The elliptical trainers would sell for $ 2,000 each and havea variable cost of $500 each. The annual fixed costs associatedwith production would be $1,000,000. In addition, there would be a$5,000,000 initial expenditure associated with the purchase of newproduction equipment. It is assumed that this initial expenditurewill be depreciated using the straight- line method down to zeroover 5 years. This project will also require a one- time initialinvestment of $1,000,000 in working capital associated withinventory. The introduction of this new elliptical trainer willreduce the sales of an existing training machine that the companycurrently sells. The company estimates that $250,000 per yearbefore tax basis will be lost on this existing training machine ifthe new elliptical trainer is introduced. At the end of the 5thyear, the company estimates selling the production equipment for$150,000. Finally, assume that the firm’s marginal tax rate is 34percent.
a) What is the initial outlay associated with this project?
b) What are the annual after- tax operating cash flowsassociated with this project for years
1 through 4?
c) What is the non-operating cash flow in year 5 or the terminalvalue?
d) What is the project’s NPV given a 10 percent cost ofcapital?

Answer & Explanation Solved by verified expert

3.7 Ratings (435 Votes)

Elliptical	0	1	2	3	4	5
Invesment	-$5,000,000
NWC	-$1,000,000					$1,000,000
Salvage						$150,000
Sales		$10,000,000	$10,000,000	$10,000,000	$10,000,000	$10,000,000
VC		-$2,500,000	-$2,500,000	-$2,500,000	-$2,500,000	-$2,500,000
FC		-$1,000,000	-$1,000,000	-$1,000,000	-$1,000,000	-$1,000,000
Cannibalization		-$250,000	-$250,000	-$250,000	-$250,000	-$250,000
Depreciation		-$1,000,000	-$1,000,000	-$1,000,000	-$1,000,000	-$1,000,000
EBT		$5,250,000	$5,250,000	$5,250,000	$5,250,000	$5,250,000
Tax (34%)		-$1,785,000	-$1,785,000	-$1,785,000	-$1,785,000	-$1,785,000
Net Income		$3,465,000	$3,465,000	$3,465,000	$3,465,000	$3,465,000
Cash Flows	-$6,000,000	$4,465,000	$4,465,000	$4,465,000	$4,465,000	$5,564,000
NPV	$11,608,255.46

Initial Outlay = -5,000,000 - 1,000,000 = -6,000,000

OCF = Net Income + Depreciation = 4,465,000

Non-operating cash flows in year 5 = NWC + Salvage x (1 - tax) = 1,000,000 + 150,000 x (1 - 34%) = $1,099,000

NPV can be calculated using 10% discount rate and above cash flows on a calculator or using formula

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Transcribed Image Text

A company is considering manufacturing new elliptical trainers.This company did a marketing research 2 years ago, paying $750,000consulting fees and found that the market is ripe for such a newproduct. The company feels that they can sell 5,000 of these peryear for 5 years (after which time this project is expected to shutdown). The elliptical trainers would sell for $ 2,000 each and havea variable cost of $500 each. The annual fixed costs associatedwith production would be $1,000,000. In addition, there would be a$5,000,000 initial expenditure associated with the purchase of newproduction equipment. It is assumed that this initial expenditurewill be depreciated using the straight- line method down to zeroover 5 years. This project will also require a one- time initialinvestment of $1,000,000 in working capital associated withinventory. The introduction of this new elliptical trainer willreduce the sales of an existing training machine that the companycurrently sells. The company estimates that $250,000 per yearbefore tax basis will be lost on this existing training machine ifthe new elliptical trainer is introduced. At the end of the 5thyear, the company estimates selling the production equipment for$150,000. Finally, assume that the firm’s marginal tax rate is 34percent.a) What is the initial outlay associated with this project?b) What are the annual after- tax operating cash flowsassociated with this project for years1 through 4?c) What is the non-operating cash flow in year 5 or the terminalvalue?d) What is the project’s NPV given a 10 percent cost ofcapital?