McGilla Golf has decided to sell a new line of golf clubs and would like to know
ID: 2730312 • Letter: M
Question
McGilla Golf has decided to sell a new line of golf clubs and would like to know the sensitivity of NPV to changes in the price of the new clubs and the quantity of new clubs sold. The clubs will sell for $770 per set and have a variable cost of $370 per set. The company has spent $147,000 for a marketing study that determined the company will sell 59,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 9,200 sets of its high-priced clubs. The high-priced clubs sell at $1,070 and have variable costs of $670. The company will also increase sales of its cheap clubs by 10,700 sets. The cheap clubs sell for $410 and have variable costs of $215 per set. The fixed costs each year will be $9,070,000. The company has also spent $1,080,000 on research and development for the new clubs. The plant and equipment required will cost $28,490,000 and will be depreciated on a straight-line basis. The new clubs will also require an increase in net working capital of $1,270,000 that will be returned at the end of the project. The tax rate is 38 percent, and the cost of capital is 12 percent. What is the sensitivity of the NPV to each of these variables? (Do not round intermediate calculations and round your final answers to 2 decimal places (e.g., 32.16).) NPV NPV/P $ NPV/Q $
Explanation / Answer
Answer: The marketing study and the research and development are both sunk costs and should beignored. We will calculate the sales and variable costs first. Since we will lose sales of theexpensive clubs and gain sales of the cheap clubs, these must be accounted for as erosion.
For the variable costs, we must include the units gained or lost from the existing clubs. Note thatthe 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:
The pro forma income statement will be:
Calculation of NPV is:
NPV = –$28,490,000 – 1,270,000 + $9,567,230(PVIFA12%,7) + $1,270,000/1.127
NPV= $14476991.97
To calculate the sensitivity of the NPV to changes in the price of the new club, we simply need tochange the price of the new club. We will choose $800, but the choice is irrelevant as thesensitivity will be the same no matter what price we choose.
Calculation of NPV is:
NPV = –$28,490,000 – 1,270,000 +$10,664,630 (PVIFA12%,7) + $1,270,000/1.127
NPV= $19485258.40
So, the sensitivity of the NPV to changes in the price of the new club is:
NPV/P = ( $14476991.97–$19485258.40 )/($770– 800)
NPV/P=$166,942.21
For every dollar increase (decrease) in the price of the clubs, the NPV increases (decreases) by $166,942.21.
To calculate the sensitivity of the NPV to changes in the quantity sold of the new club, we simplyneed to change the quantity sold. We will choose 60,000 units, but the choice is irrelevant as thesensitivity will be the same no matter what quantity we choose.
Calculation of NPV at this quantity is:
NPV = –$28,490,000 – 1,270,000 +$9,815,230 (PVIFA12%,7) + $1,270,000/1.127
NPV= $15608803.60
So, the sensitivity of the NPV to changes in the quantity sold is:
change in NPV/change in Q = ( $14476991.97– $15608803.60)/(59000 – 60,000)
change in NPV/change in Q = $1,131.81
For an increase (decrease) of one set of clubs sold per year, the NPV increases (decreases) by $1,131.81.
Sales: New clubs 770*59000 45430000 Exp. Clubs 1070*-9200 -9844000 Cheap Clubs 410*10700 4387000 39973000