McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell f
ID: 2790414 • Letter: M
Question
McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell for $870 per set and have a variable cost of $470 per set. The company has spent $157,000 for a marketing study that determined the company will sell 61,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 10,200 sets of its high-priced clubs. The high-priced clubs sell at $1,170 and have variable costs of $770. The company will also increase sales of its cheap clubs by 11,700 sets. The cheap clubs sell for $510 and have variable costs of $265 per set. The fixed costs each year will be $9,170,000. The company has also spent $1,180,000 on research and development for the new clubs. The plant and equipment required will cost $29,190,000 and will be depreciated on a straight-line basis. The new clubs will also require an increase in net working capital of $1,370,000 that will be returned at the end of the project. The tax rate is 30 percent, and the cost of capital is 10 percent. Suppose you feel that the values are accurate to within only ±10 percent. What are the best-case and worst-case NPVs? (Hint: The price and variable costs for the two existing sets of clubs are known with certainty; only the sales gained or lost are uncertain.) (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
The answers are NOT: $65,324,436.22 and $11,752,906.03 nor Worst case NPV = -17,254,602.21 and best case NPV = 70,826,132.40
Explanation / Answer
In the two situations, i.e., worst-case or best-case, we will only change those parts that were part of the marketing study except for price and variable costs for the two existing sets. In case of best-case, the positive flows like sales will increase and negative flows like variable cost will decrease and it would be opposite in case of worst-case -
The costs spend on market study and research and developement will not be considered in computation of initial investment as they are sunk costs.
Initial Investment = Cost of plant and equipment + increase in net working capital = $29190000 + $1370000 = $30,560,000
Depreciation per year = $29,190,000 / 7 = $4,170,000
Depreciation tax shield per year = $4,170,000 x 30% = $1,251,000
Now, we compute NPV under both the situations -
Best - Case NPV
Sales per year = Sale of new clubs - decrease in sale of high-priced clubs + increase in sales of cheap clubs
or, Sales per year = 67100 x $957 - 9180 x $1170 + 12870 x $510 = $60,037,800
Variables costs per year = Variable cost of new clubs - reduced variable costs of high price clubs + increased variable costs of cheap clubs
or, Variable costs per year = 67100 x $423 - 9180 x $770 + 12870 x $265 = $24,725,250
Total cash inflows per year = (Sales - Variable costs - fixed costs) x (1 - tax rate) + Depreciation tax shield
or, Total cash inflows per year = ($60,037,800 - $24,725,250 - $8,253,000) x (1 - 0.30) + $1,251,000 = $20,192,685
NPV = Cash Inflows per year x PVIFA (10%, 7) + Working capital recovered x PVIF (10%, 7) - Initial Investment
or, NPV = $20,192,685 x 4.86841881764 + $1,370,000 x 0.51315811821 - $30,560,000 = $68,449,474.25
Worst - Case NPV
Sales per year = Sale of new clubs - decrease in sale of high-priced clubs + increase in sales of cheap clubs
or, Sales per year = 54900 x $783 - 11220 x $1170 + 10530 x $510 = $35,229,600
Variables costs per year = Variable cost of new clubs - reduced variable costs of high price clubs + increased variable costs of cheap clubs
or, Variable costs per year = 54900 x $517 - 11220 x $770 + 10530 x $265 = $22,534,350
Total cash inflows per year = (Sales - Variable costs - fixed costs) x (1 - tax rate) + Depreciation tax shield
or, Total cash inflows per year = ($35,229,600 - $22,534,350 - $10,087,000) x (1 - 0.30) + $1,251,000 = $3,076,775
NPV = Cash Inflows per year x PVIFA (10%, 7) + Working capital recovered x PVIF (10%, 7) - Initial Investment
or, NPV = $3,076,775 x 4.86841881764 + $1,370,000 x 0.51315811821 - $30,560,000 = (-)$14,877,944.07
Particulars As per Marketing study Best-Case Worst-Case New clubs Units sold 61000 sets 61000 + 10% = 67100 sets 61000 - 10% = 54900 sets Selling price 870 $870 + 10% = $957 $870 - 10% = $783 Variable cost 470 $470 - 10% = $423 $470 + 10% = $517 High-priced clubs Decrease in units sold 10200 sets 10200 - 10% = 9180 sets 10200 + 10% = 11220 sets Cheap clubs Increase in units sold 11700 sets 11700 + 10% = 12,870 11700 - 10% = 10530 sets Fixed Costs $9,170,000 $9170000 - 10% = $8,253,000 $9170000 + 10% = $10,087,000