PROBLEM #1
Casey's Cycles manufactures a line of traditional multi-speed road bicycles. Management is considering a new business proposal to produce a line of off-road mountain bikes. The proposal has been studied carefully and the following information is forecast:
Cost of new production equipment and machinery including freight and setup $200,000 with a 5 year life (assume straight line depreciation applies)
Expense of hiring and training new employees pre-startup $125,000
Pre-start-up advertising and other miscellaneous expenses $20,000
Initial inventory required to service sales $12,000 (does not vary over the life of the project will be sold off at end of project). This is the only working capital for this project.
Additional selling and administrative expense per year after start-up $120,000
Sales Forecasts
Year 1 : 500 units
Year 2: 1200 units
Year 3: 1500 units
Sales Price: $600
Unit cost to manufacture (60% of revenue): $360
If Casey Cycles does this project to make off-road bicycles they expect to lose some of its current sales to the new product. Three percent of the new unit forecast is expected to come out of sales that would have gone to the old line. You can assume that prices and profit margins are identical for the old and the new bicycles.
Casey Cycles has a 35% tax rate and wants to estimate the cash flows of this project over the next 3 years. Assume that the initial inventory is liquidated at its current value at the end of three years and that the new equipment is sold at itsbook value in 3 years.
Make sure that you remember that Casey Cycles is an existing company and so any tax savings on losses could be used to offset taxes on other lines of business. Assume that these tax savings can be fully absorbed in the year they are incurred.
What is the IRR of this project? If Casey thought she could earn 15% on other investments, would you recommend she do this project? What is the NPV of this project?