At present, Solartech Skateboards is considering expanding its product line to include gas-powered skateboards; however, it is questionable how well they will be received by skateboarders. Although you feel there is a 50 percent chance you will sell 9000 of these per year for 10 years (after which time this project is expected to shut down because solar-powered skateboards will become more popular), you also recognize that there is a 25 percent chance that you will only sell 1000 and also a 25 percent chance you will sell 15000 . The gas skateboards would sell for 140 each and have a variable cost of $ 50 each. Regardless of how many you sell, the annual fixed costs associated with production would be $120,000. In addition, there would be an initial expenditure of $120,0000 associated with the purchase of new production equipment which will be depreciated using the bonus depreciation method in year 1. Because of the number of stores that will need inventory, the working capital requirements are the same regardless of the level of sales. This project will require a one-time initial investment of 60000 in net working capital, and working-capital investment will be recovered when the project is shut down. Finally, assume that the firm’s marginal tax rate is 24 percent.
a. What is the initial outlay associated with the project?
b. What are the annual free cash flows associated with the project for years 1, and 2 through 9 under each sales forecast? What are the expected annual free cash flows for year 1, and years 2 through 9?
c. What is the terminal cash flow in year 10 (that is, what is the free cash flow in year 10 plus any additional cash flows associated with the termination of the project)?
d. Using the expected free cash flows, what is the project’s NPV given a required rate of return of
11
percent? What would the project’s NPV be if
9,000
skateboards were sold?
Solartech Skateboards is contemplating diversifying its product range by introducing gas-powered skateboards. However, the success of this expansion is uncertain as it depends on factors such as sales projections, costs, and market trends. To assess the viability of this project, we will analyze various financial aspects including initial outlay, annual free cash flows, terminal cash flow, and net present value (NPV) at different sales levels.
The initial outlay includes both the initial capital investment and the net working capital required. The project necessitates an initial investment of $120,000 in production equipment, which will be depreciated using the bonus depreciation method in year 1. Additionally, a net working capital investment of $60,000 is required. Therefore, the initial outlay is $120,000 (equipment) + $60,000 (net working capital) = $180,000.
Annual Free Cash Flows: To calculate the annual free cash flows, we need to consider the sales forecasts and associated costs. There are three potential sales scenarios: 9,000 units, 1,000 units, and 15,000 units. Each unit of gas skateboard is priced at $140 with a variable cost of $50 per unit. Annual fixed costs are $120,000. The calculations for the first year are as follows:
Scenario 1 (9,000 units): Revenue: 9,000 * $140 = $1,260,000 Variable Costs: 9,000 * $50 = $450,000 Gross Profit: $1,260,000 – $450,000 = $810,000 Operating Income: $810,000 – $120,000 = $690,000
Scenario 2 (1,000 units): Revenue: 1,000 * $140 = $140,000 Variable Costs: 1,000 * $50 = $50,000 Gross Profit: $140,000 – $50,000 = $90,000 Operating Income: $90,000 – $120,000 = -$30,000 (loss)
Scenario 3 (15,000 units): Revenue: 15,000 * $140 = $2,100,000 Variable Costs: 15,000 * $50 = $750,000 Gross Profit: $2,100,000 – $750,000 = $1,350,000 Operating Income: $1,350,000 – $120,000 = $1,230,000
The annual free cash flows for years 1, and 2 through 9 for each sales forecast can be calculated using the formula: Free Cash Flow = Operating Income – Taxes + Depreciation – Capital Expenditures ± Change in Working Capital.
In year 10, the project is expected to shut down due to the rise in popularity of solar-powered skateboards. This year’s terminal cash flow is calculated by considering the remaining book value of the production equipment, which has been fully depreciated using the bonus depreciation method in year 1.
The NPV of the project represents the difference between the present value of expected future cash flows and the initial outlay. The NPV formula is: NPV = Σ[CFt / (1 + r)^t] – Initial Outlay, where CFt is the expected cash flow in year t, r is the required rate of return (11%), and t represents the year.
By considering the initial outlay, annual free cash flows, terminal cash flow, and NPV, Solartech Skateboards can make an informed decision about expanding its product line to include gas-powered skateboards. The NPV analysis, taking into account various sales scenarios, will provide valuable insights into the financial feasibility of this expansion and guide the company’s strategic choices in the dynamic skateboard market.
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