XYZ Company

Solution

The XYZ Company is considering investment in equipment to produce a new product. XYZ conducted a market test costing $100,000 and concluded that the new product has a high probability of success. The equipment would cost $600,000 and qualify for straight-line depreciation for tax purposes. Expected annual cash receipts of $600,000 and incremental material and direct labor cash expenditures of $300,000 would be incurred over the 5-year project life. In addition, the project would assume a $50,000 annual share of existing overhead expenses that would be incurred by XYZ whether or not the new product was accepted. The new project would require $100,000 in net working capital (inventory and accounts receivable, net of accounts payable and taxes payable) support throughout its life. At the end of the project life, the equipment could be sold for $100,000 an amount exactly equal to its existing book value.

XYZ’s tax rate is 40%. The firm’s required rate of return, or WACC, is 15%.

1)Identify the conceptual errors in the following analysis of the new product. State the correct treatment. Note: Tax and computational errors deriving from conceptual error are not to be cited as separate items.

  • The analyst included the marketing test cost. This item is a “sunk cost.”
  • The analyst included net working capital every year. In this case, net working capital should be an outflow at t = 0 but have no impact in years 1-4 as its level does not change.
  • The analyst fail to “flow” net working capital back in at t = 5.
  • The analyst allocated existing overhead to the new project. This overhead is “fixed” and would be incurred with or without the new project.
  • The analyst failed to recognize the salvage value of the equipment. This inflow should be included at t = 5. Since the net book value at t = 5 is $100, which is equal to the estimated salvage value, no gain or loss on disposal occurs so no tax consequences exist.

2)What is the NPV that you calculate for this new product after eliminating the conceptual errors?

( All figures in $000 )

Time Period / 0 / 1 / 2 / 3 / 4 / 5
Investment / -$600
Marketing Test Costs / none
Net Working Capital / -$100 / $100
Salvage Net of Tax / $100
Cash Receipts / $600 / $600 / $600 / $600 / $600
Expenditures:
Out-Of-Pocket / -$300 / -$300 / -$300 / -$300 / -$300
Overhead / none / none / none / none / none
Depreciation / -$100 / -$100 / -$100 / -$100 / -$100
Earnings Before Taxes / $200 / $200 / $200 / $200 / $200
Taxes @ 40% / -$ 80 / -$ 80 / -$ 80 / -$ 80 / -$ 80
Earnings After Taxes / $120 / $120 / $120 / $120 / $120
+Depreciation / $100 / $100 / $100 / $100 / $100
=Operating Cash Flow / $220 / $220 / $220 / $220 / $220
Net Cash Flow / -$700 / $220 / $220 / $220 / $220 / $420

NPV @ 15%

/ $137