McGilla Golf has decided to sell a new line of golf clubs. The length of this pr
ID: 2764811 • Letter: M
Question
McGilla Golf has decided to sell a new line of golf clubs. The length of this project is seven years. The company has spent $1981464 on research and development for the new clubs. The plant and equipment required will cost $28824073 and will be depreciated on a straight-line basis. The new clubs will also require a net working capital of $1268292 that will be returned at the end of the project. The annual OCF of the project will be $8358851. The tax rate is 28 percent, and the cost of capital is 12 percent. What is the payback period for this project?
Explanation / Answer
Working notes:
(1) Annual depreciation = $28,824,073 / 7 = $4,117,725
(2) First cost = Plant & equipment + Net working capital (NWC) = $(28,824,073 + 1,268,292) = $30,092,365
(3) Annual OCF, year 7 = $(8,358,851 + 1,268,292) = $9,627,143 (NWC recovery)
(4) Research/development cost is a sunk cost & excluded from cash flow analysis.
(5) Annual pre-tax profit = Annual OCF - Depreciation
(6) Annual after-tax profit = Pre-tax profit x (1 - tax rate) = Pre-tax profit x 0.72
(7) Cash flow after tax (ATCF) = After-tax profit + Depreciation (this being non-cash expense, is added back)
(8) It is assumed that recovered NWC is taxable. Relaxation of this assumption will change the result.
(9) Payback period (PBP) is the time by when the project's ATCF recovers its first cost. Since question doesn't mention discounted PBP, we compute simple PBP (with undiscounted cash flows).
So,
PBP falls between year 4 & 5. So,
PBP = 4 + (Absolute value of cumulative cash flow, year 4 / Cash flow, year 5)
= 4 + (1,407,022 / 7,171,336) = 4 + 0.20 = 4.2 years
Cash Flow Year OCF Depreciation Pre-tax profit Post-tax profit ATCF A B C = A - B D = C x 0.72 E = D + B 1 83,58,851 41,17,725 42,41,126 30,53,611 71,71,336 2 83,58,851 41,17,725 42,41,126 30,53,611 71,71,336 3 83,58,851 41,17,725 42,41,126 30,53,611 71,71,336 4 83,58,851 41,17,725 42,41,126 30,53,611 71,71,336 5 83,58,851 41,17,725 42,41,126 30,53,611 71,71,336 6 83,58,851 41,17,725 42,41,126 30,53,611 71,71,336 7 96,27,143 41,17,725 55,09,418 39,66,781 80,84,506