Problem - Existing asset
Replacement problem
Problem 1:
Consider the following for an 8 year special revenue generating project. (this is the base case)
- Sales revenue $250,000 in the first year and will increase by 20% per year for the next 4 years.In year 6 the revenue will decrease by 15% a year through year 8.There is no expected cash flow after 8 years as this venture has a constrained timeline and no expected value after 8 years.
- Costs of goods sold will be 70% of sales.
- Advertising and administrative expenses will be fixed at $10,000 per year.
- Equipment will be purchased for $300,000 and will be depreciated using the 7 year MACRS asset class depreciation schedule.Salvage value is expected to be $25,000
- Working capital investment in year 0 is estimated to be $20,000 and is expected to be recovered in the final year of the project.
Cost of Capital is 8% and Tax Rate is 30%.
A: Base Case scenario
Calculate the project's NPV
What is your recommendation?
B: Pessimistic View
What is the impact on NPV based on pessimistic assumptions (consider both at the same time):
- If Sales Revenue in the first year was only $150,000 and only increase by 10% for the next 4 years and then decline by 20% a year through year 8?
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- If Cost of Goods Sold were 75% of sales?