McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell f
ID: 2736606 • Letter: M
Question
McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell for $760 per set and have a variable cost of $360 per set. The company has spent $146,000 for a marketing study that determined the company will sell 58,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 9,100 sets of its high-priced clubs. The high-priced clubs sell at $1,060 and have variable costs of $660. The company will also increase sales of its cheap clubs by 10,600 sets. The cheap clubs sell for $400 and have variable costs of $210 per set. The fixed costs each year will be $9,060,000. The company has also spent $1,070,000 on research and development for the new clubs. The plant and equipment required will cost $28,420,000 and will be depreciated on a straight-line basis. The new clubs will also require an increase in net working capital of $1,260,000 that will be returned at the end of the project. The tax rate is 40 percent, and the cost of capital is 12 percent. -Calculate the payback period. -Calculate the NPV -Calculate the IRR. (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).)
Explanation / Answer
The marketing study and the research and development are both sunk costs and should be ignored. The initial cost is the equipment plus the net working capital, so :
Initial cost = $ 28,420,000 + 1,260,000
Initial cost = $29,680,000
Next, we will calculate the sales and variable costs. 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 $760 × 58,000 = $44,080,000
Exp. Clubs $1,060 × (–9,100) = –9,646,000
Cheap clubs $400 × 10,600 = 4,240,100
$38,674,000
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 :
Variable Costs
New clubs $360 × 58,000 = $20,880,000
Exp. Clubs $660 × (–9,100) = –6,006,000
Cheap clubs $210 × 10,600 = 2,226,000
$17,100,000
The pro forma income statement will be :
Sales $38,674,000
Variable costs $17,100,000
Costs $9,060,000
Depreciation $4,060,000
EBIT $8,454,000
Taxes $3,381,600
Net income $5,072,400
Using the bottom up OCF calculation, we get :
OCF = NI + Depreciation
OCF = $5,072,400 + 4,060,000
CF = $9,132,400
So, the payback period is :
Payback period = 3 + $2,282,800/$9,132,400
Payback period = 3.25 years
The NPV is :
NPV = –$29,680,000 + $9,132,400 (PVIFA12%,7) + $1,260,000/1.12^7
NPV = $12,568,010.23
And the IRR is:
0 = –$29,680,000 + $9,132,400 (PVIFAIRR%,7) + $1,260,000/IRR^7
IRR = 24.27%