McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell f
ID: 2702498 • Letter: M
Question
McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell for $900 per set and have a variable cost of $400 per set. The company has spent $197,000 for a marketing study that determined the company will sell 72,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 15,000 sets of its high-priced clubs. The high-priced clubs sell at $1,400 and have variable costs of $700. The company will also increase sales of its cheap clubs by 13,000 sets. The cheap clubs sell for $500 and have variable costs of $200 per set. The fixed costs each year will be $9,856,000. The company has also spent $1,281,000 on research and development for the new clubs. The plant and equipment required will cost $22,400,000 and will be depreciated on a straight-line basis. The new clubs will also require an increase in net working capital of $1,230,000 that will be returned at the end of the project. The tax rate is 40 percent, and the cost of capital is 12 percent.
McGilla Golf would like to know the sensitivity of NPV to changes in the price of the new clubs and the quantity of new clubs sold.
What is the sensitivity of the NPV to changes in the price of the new club? (Do not round your intermediate calculations.)
What is the sensitivity of the NPV to changes in the quantity sold? (Do not round your intermediate calculations.)
McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell for $900 per set and have a variable cost of $400 per set. The company has spent $197,000 for a marketing study that determined the company will sell 72,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 15,000 sets of its high-priced clubs. The high-priced clubs sell at $1,400 and have variable costs of $700. The company will also increase sales of its cheap clubs by 13,000 sets. The cheap clubs sell for $500 and have variable costs of $200 per set. The fixed costs each year will be $9,856,000. The company has also spent $1,281,000 on research and development for the new clubs. The plant and equipment required will cost $22,400,000 and will be depreciated on a straight-line basis. The new clubs will also require an increase in net working capital of $1,230,000 that will be returned at the end of the project. The tax rate is 40 percent, and the cost of capital is 12 percent.
McGilla Golf would like to know the sensitivity of NPV to changes in the price of the new clubs and the quantity of new clubs sold.
Explanation / Answer
To calculate the sensitivity of the NPV to changes in the
price of the new club, we simply need to change the price
of the new club. We will choose $950, but the choice is
irrelevant as the sensitivity will be the same no matter
what price we choose.
We will calculate the sales and variable costs first.
Since we will lose sales of the expensive clubs and gain
sales of the cheap clubs, these must be accounted for as
erosion. The total sales for the new project at Old rate
of $900 will be:
Sales :
New clubs $900* 72000 = $64800000
Exp. clubs $1400*(-15000) = $(21000000)
Cheap clubs $500 *13000 = $6,500,000
-----------------------------------------
$50,300,000
For the variable costs, we must include the units gained or
lost from the existing clubs. Note that the variable costs of
the expensive clubs are an inflow. If we are not producing the
sets anymore, we will save these variable costs, which is an
inflow. So:
Var. costs :
New clubs $400 * 72000 = $28800000
Exp. clubs $700 *(-15000) = $(10500000)
Cheap clubs $200 *13000 = $2600000
---------------------------------------------
$20900000
The pro forma income statement will be:
Sales $50,300,000
Variable costs $20900000
Fixdd Costs 9,856,000
Depreciation($22,400,000/7) 3200000
---------------------------------
EBT 16344000
Taxes (40%) -6537600
--------------------------------
Net income 9806400
Using the bottom up OCF calculation, we get:
OCF = NI + Depreciation = 9806400 + 3200000
OCF = 13006400
And the NPV is:
NPV = Inital Inv + Increase in Wrkg cap + OCF(PVA 12%,7)
+ Recovery of Wrkg Cap*PV(12%,7)
ie NPV = -22400000 - 1230000 + 13006400*4.5638 +
1230000*0.4523
ie NPV = 36284937.32 .........................(A)
Sales :
New clubs $950* 72000 = $68400000
Exp. clubs $1400*(-15000) = $(21000000)
Cheap clubs $500 *13000 = $6,500,000
-----------------------------------------
$53900000
For the variable costs, we must include the units gained or
lost from the existing clubs. Note that the variable costs
of the expensive clubs are an inflow. If we are not producing
the sets anymore, we will save these variable costs, which
is an inflow. So:
Var. costs :
New clubs $400 * 72000 = $28800000
Exp. clubs $700 *(-15000) = $(10500000)
Cheap clubs $200 *13000 = $2600000
---------------------------------------------
$20900000
The pro forma income statement will be:
Sales $53900000
Variable costs $20900000
Fixdd Costs 9,856,000
Depreciation($22,400,000/7) 3200000
---------------------------------
EBT 19944000
Taxes (40%) -7977600
--------------------------------
Net income 11966400
Using the bottom up OCF calculation, we get:
OCF = NI + Depreciation = 11966400 + 3200000
OCF = 15166400
And the NPV is:
NPV = Inital Inv + Increase in Wrkg cap + OCF(PVA 12%,7)
+ Recovery of Wrkg Cap*PV(12%,7)
ie NPV = -22400000 - 1230000 + 15166400*4.5638
+ 1230000*0.4523
ie NPV = $46,142,745.32 .............(B)
So, the sensitivity of the NPV to changes in the price of
the new club is:
%u0394NPV/%u0394P = (46142745.32 -36284937.32)/(950 %u2013 900)
%u0394NPV/%u0394P = $197,154.28
For every dollar increase (decrease) in the price of the
clubs, the NPV increases (decreases)
by $197,154.28 .......Ans (1)
To calculate the sensitivity of the NPV to changes in the
quantity sold of the new club, we simply need to change the
quantity sold. We will choose 80,000 units, but the choice
is irrelevant as the sensitivity will be the same no matter
what quantity we choose.
We will calculate the sales and variable costs first. Since
we will lose sales of the expensive clubs and gain sales of
the cheap clubs, these must be accounted for as erosion.
The total sales for the new project will be:
Sales :
New clubs $900* 72000 = $64800000
Exp. clubs $1400*(-15000) = $(21000000)
Cheap clubs $500 *13000 = $6,500,000
-----------------------------------------
$50,300,000
For the variable costs, we must include the units gained or
lost from the existing clubs. Note that the variable costs
of the expensive clubs are an inflow. If we are not producing
the sets anymore, we will save these variable costs, which is
an inflow. So:
Var. costs :
New clubs $400 * 72000 = $28800000
Exp. clubs $700 *(-15000) = $(10500000)
Cheap clubs $200 *13000 = $2600000
---------------------------------------------
$20900000
The pro forma income statement will be:
Sales $50,300,000
Variable costs $20900000
Fixdd Costs 9,856,000
Depreciation($22,400,000/7) 3200000
---------------------------------
EBT 16344000
Taxes (40%) -6537600
--------------------------------
Net income 9806400
Using the bottom up OCF calculation, we get:
OCF = NI + Depreciation = 9806400 + 3200000
OCF = 13006400
And the NPV is:
NPV = Inital Inv + Increase in Wrkg cap + OCF(PVA 12%,7)
+ Recovery of Wrkg Cap*PV(12%,7)
ie NPV = -22400000 - 1230000 + 13006400*4.5638
+ 1230000*0.4523
ie NPV = 36284937.32 .........................(A)
Sales :
New clubs $900* 80000 = $72000000
Exp. clubs $1400*(-15000) = $(21000000)
Cheap clubs $500 *13000 = $6,500,000
-----------------------------------------
$57500000
For the variable costs, we must include the units gained or
lost from the existing clubs. Note that the variable costs
of the expensive clubs are an inflow. If we are not producing
the sets anymore, we will save these variable costs, which
is an inflow. So:
Var. costs :
New clubs $400 * 80000 = $32000000
Exp. clubs $700 *(-15000) = $(10500000)
Cheap clubs $200 *13000 = $2600000
---------------------------------------------
$24100000
The pro forma income statement will be:
Sales $57500000
Variable costs $24100000
Fixdd Costs 9,856,000
Depreciation($22,400,000/7) 3200000
---------------------------------
EBT 20344000
Taxes (40%) -8137600
--------------------------------
Net income 12206400
Using the bottom up OCF calculation, we get:
OCF = NI + Depreciation = 12206400 + 3200000
OCF = 15406400
And the NPV is:
NPV = Inital Inv + Increase in Wrkg cap + OCF(PVA 12%,7)
+ Recovery of Wrkg Cap*PV(12%,7)
ie NPV = -22400000 - 1230000 + 15406400*4.5638
+ 1230000*0.4523
ie NPV = $47,238,057.32 .............(B)
So, the sensitivity of the NPV to changes in the price
of the new club is:
%u0394NPV/%u0394P = (47238057.32 -36284937.32)/(80000-72000)
%u0394NPV/%u0394P = $1,369.13
For an increase (decrease) of one set of clubs sold per
year, the NPV increases (decreases) by
$1,369.13 .......Ans (2)