Rusty Williams, the owner and CEO of The Rusty Bicycle Company,a small manufacturer and distributer of recreational bikes, hasdejectedly watched sales of his company’s flagship bike, theWindRunner, decline precipitously over the past 7 years. Believingthat the trend is irreversible, Rusty has taken the drastic step ofshutting down the operation of his firm in an effort to reducecosts while he tries to figure out how to rescue the firm he hasspent the bulk of his life building.

Rusty asks his brother John, the head design engineer at hisfirm to design and build a prototype of a new bicycle that might beable to save the company. Rusty tells John to forget aboutconventional bicycle design and to “think big” and come up withsomething truly revolutionary.

After about 6 weeks of intense work, John comes back to Rustywith a proposal for the “WindRunner 2.0”, a bicycle unlike anythingelse on the market today. John believes that the specialty natureof the new bicycle suggests that, while unit sales volume may berelatively low, the bicycle should command a premium sales price.Specifically, he thinks that customers would be willing to payupwards of $845 per bike.

Rusty, intrigued by the new design, hires a market researchconsultant, Sandy Frazier, to study the potential demand for theWindRunner 2.0. As projecting demand for a completely new productis notoriously difficult, she limits her prediction to a 5 yearhorizon. Sandy gives the following forecast to Rusty in exchangefor her customary fee of $45,000.

Year	Sales Volume
1	7,000
2	7,000
3	7,000
4	7,000
5	7,000

Rusty is optimistic that the expected sales revenue will beenough to save his company. Deciding to move forward on theevaluation of this project, he asks John what new manufacturingcapacity will be needed to begin production. John thinks that hecould reconfigure the firm’s current manufacturing facility toproduce the new model bicycle, although the current productionmachinery, purchased over 20 years ago, is woefully inadequate. Heestimates that the necessary new equipment could be purchased for$2.5 million and that the whole manufacturing process will incurfixed operating costs of $3 million per year. Additionally, heestimates the variable costs of production to run $260 per bikeproduced.

John further thinks that the existing production equipment,which will no longer be needed, could be sold for $400,000. Theexisting equipment was classified for tax purposes under the 15year MACRS category. As a result of a recent exemption given tosmall businesses, Rusty will not have to use the MACRS depreciationschedules for new capital assets acquired. Instead, the newequipment will be depreciated straight-line to zero over the 5 yearplanning horizon. John thinks that the new production equipmentwill be worthless and scrapped at the end of 5 years.

Finally, John tells Rusty that he will need about $300,000 inraw materials (i.e. parts and supplies) for the bicycles to beginproduction. This expenditure will not be recovered at the end ofthe project. Rusty, worried about spending so much cash on parts,calls a supplier, Rodney Murdock, to see about short-term creditoptions. Unfortunately, due to the precarious position Rusty findshis company in, the supplier is unable to offer any credit termsand will insist upon cash on delivery payment for rawmaterials.

Recently, a federal government economic stimulus measure wasenacted. As a result of this effort, small businesses, like Rusty,will have their business income tax rate cut to zero percent forthe next 10 years. The intent is to stimulate the formation of newsmall businesses throughout the country. Since this project is alast ditch effort to save the company, Rusty plans to let theproject run for the 5 year forecast horizon. After that, he plansto dissolve the business and retire. Due to the desperationinvolved in this project, Rusty estimates that a 20% required rateof return is appropriate.

Rusty has asked for your help in addressing the followingquestions.

Prepare a 5 year forecast of cash flow from assets (CFA) for theWindRunner 2.0 project.

	1	2	3	4	5
Sales Volume
Price
Revenue
Fixed Costs
Variable Costs per unit

Income Statement	1	2	3	4	5
Sales
Expenses
Depreciation
EBIT
Taxes
Net Income

Cash Flows	0	1	2	3	4	5
Operating Cash Flows
Net Working Capital
Capital Expenditure
Salvage
Cash Flow from Assets

Calculate the Net Present Value (NPV) of the WindRunner 2.0project.

Since the future of his company rests on the success or failureof this project, Rusty is understandably concerned about risks tohis forecasts and expectations for the project. To get a betterpicture of the risk involved, Rusty again asks you to conduct thefollowing scenario analyses.   

With your previous work being used as the ‘base case’ scenario,estimate the net present value of the project under a pessimisticscenario. Specifically, Rusty wants to consider the project’s NPVif both sales volume and the sales price are 10% below the basecase scenario, while variable costs are 10% above the base casescenario estimates. All other variables will remain the same.

	1	2	3	4	5
Sales Volume
Price
Revenue
Fixed Costs
Variable Costs per unit

Income Statement	1	2	3	4	5
Sales
Expenses
Depreciation
EBIT
Taxes
Net Income

Cash Flows	0	1	2	3	4	5
Operating Cash Flows
Net Working Capital
Capital Expenditure
Salvage
Cash Flow from Assets

Now, to look at the optimistic case, reevaluate the project NPVwhere sales volume and sales price are 10% above the base caseestimates, while variable costs are 10% below base case estimates.Again, all other variables are presumed to remain the same.

	1	2	3	4	5
Sales Volume
Price
Revenue
Fixed Costs
Variable Costs per unit

Income Statement	1	2	3	4	5
Sales
Expenses
Depreciation
EBIT
Taxes
Net Income

Cash Flows	0	1	2	3	4	5
Operating Cash Flows
Net Working Capital
Capital Expenditure
Salvage
Cash Flow from Assets

Finally, Rusty would like to know what minimum quantity of theWindRunner 2.0 models will have to be sold in order to produce azero NPV (i.e. the financial breakeven point). That is, he wouldlike to know what level of sales volume would leave him indifferentbetween undertaking the project versus shelving theproject.