Question 6 (a-d)

Calculating Project NPV: You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago for $140,000 in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land today for $150,000 on an aftertax basis. In four years, the land could be sold for $160,000 after taxes. The company would like to use the land as its production site for the zither project. The company also hired a marketing firm to analyze the zither market, at a cost of $125,000. An excerpt of the marketing report is as follows: The zither industry will have a rapid expansion in the next four years. With the brand name recognition that PUTZ brings to bear, we feel that the company will be able to sell 3,800, 4,700, 5,300, and 4,200 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $650 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued. PUTZ believes that fixed costs for the project will be $425,000 per year, and variable costs are 15 percent of sales. The equipment necessary for production will cost $3.5 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $400,000. Net working capital of $125,000 will be required immediately. PUTZ has a 38 percent tax rate, and the required return on the project is 13 percent. a) What is the NPV of the project? What is the IRR? Should PUTZ undertake this project? b) Does your decision about undertaking the project change if we change the information regarding land to the following: The company bought some land three years ago for $1.4 million in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $1.5 million on an aftertax basis. In four years, the land cannot be re-sold (resale after tax value is $0). The company would like to use the land as its production site for the zither project. c) Does your decision about undertaking the project change if we change the information regarding land to the following: The company bought some land three years ago for $1.4 million in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $1.5 million on an aftertax basis. In four years, the land could be sold for $1.6 million after taxes. The company would like to use the land as its production site for the zither project. 6. Calculating a Bid Price: Dahlia Enterprises needs someone to supply it with 120,000 cartons of machine screws per year to support its manufacturing needs over the next five years, and youve decided to bid on the contract. It will cost you $870,000 to install the equipment necessary to start production; youll depreciate this cost straight-line to zero over the projects life. You estimate that, in five years, this equipment can be salvaged for $70,000. Your fixed production costs will be $325,000 per year, and your variable production costs should be $10.30 per carton. You also need an initial investment in net working capital of $75,000. If your tax rate is 35 percent and you require a 12 percent return on your investment: a) What bid price should you submit? An example of a solution is provided in the textbook (RWJ chapter 10. Use our E-book on Canvas, go to Part 4->Ch.10->10.6->Setting the Bid Price ). In that example, you set the project NPV equal to zero and find the required price using the definition of OCF. Thus, the bid price represents a financial break-even level for the project. This type of analysis can be extended to many other types of problems. While you can solve this problem in any way you prefer, including the one provided in the textbook, I would suggest you set up this problem as a typical valuation problem (similar to Q5 above or Q4, which we covered in class), where you start with an Income Statement, then find OCF, then you adjust OCF by net investment (and any changes in NWC) to get FCF for each year of the project. Then you discount the FCF to the present to find the NPV or the valuation of the project. However, in this problem a component of Sales (either price of quantity) will be missing. So, you will need to work your way backwards to find what that should be while setting the NPV to equal zero (for break-even analysis) This problem is supposed to encourage you to get a deeper understanding of the Income Statement and point you to the importance of SALES. This problem should also allow you to improve your Excel skills and try out the Excel Solver. b) Assume that the price per carton is $17 and find the project NPV. What does your answer tell you about your bid price? What do you know about the number of cartons you can sell and still break even? How about your level of costs? Can use Excel Solver. c) Solve the same problem again with the price still at $17, but find the quantity of cartons per year that you can supply and still break even. Hint: You are now charging a higher price per carton, accordingly you would need to sell ____ than 120,000 cartons to break even. Can use Excel Solver. d) Repeat (c) with a price of $17 and a quantity of 120,000 cartons per year, and find the highest level of fixed costs you could afford and still break even. Can use Excel Solver.