The Scenario:

You work in the product development department of an athletic apparel company. Your company has decided to add a new product and is choosing between a polo tee, yoga pants, or running shoes.

You have been asked to evaluate the financial profitability of each option. You have estimated that the company has $1,500,000 to invest in the project, and each product has the potential to bring in an estimated $2,000,000 of future cash flows, although the timing of the cash flows varies per product.

Additionally, two of the products would use equipment that could be sold at the end of the project cycle. In order to pay for the project, the company will have to finance at a 6% interest rate. Present value discount factors are listed as follows:

Formulas:Requirements

1. Calculate the profitability of each project using the following methods. Show your work.

• The payback method

• Net present value (NPV)

2. Make a decision on which product to produce by answering the Pause and Reflect questions at the end.

Option 1: Polo Shirts

1. Calculate the payback period of polo shirts. In other words, how many years will it take for the company to recoup the initial investment?

It will take the company 3.75 years.

2. Calculate the NPV of polo shirts. In other words, when comparing apples to apples (the present value of cash inflows to the present value of cash outflows), what will the expected profit of the project be?

The expected profit will be $500,000.

Option 2: Yoga Pants

3. Calculate the payback period of yoga pants. Because the equipment will be sold in the 4th year, the cash flows for each year will not be the same (they are the same for years 1-3, but not for year 4). Use the following setup to calculate the payback period for a project with unequal cash flows:

Year	Annual Net Cash Flow	Cumulative Net Cash Flows
1	$500,000	$500,000
2	$5,000,000	$10,000,000
3	$5,000,000	$1,500,000
4	$550,000	$2,050,000

4. Calculate the NPV of yoga pants.

a) Notice that for all four years the company will receive the same cash flow provided by the product. Use the PV of an annuity discount factor for this part of the calculation.

b) Notice also that the company will sell equipment in the 4th year for an additional cash flow. Which present value table should you use when calculating a single sum? Add this amount to the PV found in part a) to determine the PV of total net cash flows.

Option 3: Running Shoes

5. Calculate the payback period of running shoes.

Year	Annual Net Cash Flow	Cumulative Net Cash Flows
1
2
3
4

6. Calculate the NPV of running shoes.

a) Notice that every year the company will receive a different cash flow. In order to calculate the PV of the total net cash flows, you will need to take the individual PV of each future cash flow and add them together.

Years PV of 1 at 6% 0.94340 0.89000 0.83962 0.79209 0.74726 PV of an Annuity at 6% 0.94340 1.83339 2.67301 3.46511 4.21236 NPV = PV of total future net CF's - initial cost Payback period = cost of investment (for same CF's) annual net CF's Today's Cash Outflows Initial investment $1,500,000 Future Net Cash Flows Year 1 $400,000 Year 2 $400,000 Year 3 $400,000 Year 4 $400,000 Year 5 $400,000 Today's Cash Outflows Initial investment $1,500,000 Future Net Cash Flows Year 1 $500.000 Year 2 $500,000 Year 3 $500,000 Year 4 $500,000 Salvage Value $50,000 of Equipment Today's Cash Outflows | Initial investment $1,500,000 voor Future Net Cash Flows Year 1 $300,000 Year 2 $600.000 Year 3 $750,000 Year 4 $350,000 Salvage Value $50,000 of Equipment