91Ó°ÊÓ

McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell for \(\$ 675\) per set and have a variable cost of \(\$ 340\) per set. The company has spent \(\$ 150,000\) for a marketing study that determined the company will sell 70,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 9,000 sets per year of its high-priced clubs. The high-priced clubs sell at \(\$ 1,100\) and have variable costs of \(\$ 550 .\) The company will also increase sales of its cheap clubs by 12,000 sets per year. The cheap clubs sell for \(\$ 300\) and have variable costs of \(\$ 100\) per set. The fixed costs each year will be \(\$ 10,800,000 .\) The company has also spent \(\$ 1,000,000\) on research and development for the new clubs. The plant and equipment required will cost \(\$ 19,800,000\) and will be depreciated on a straight-line basis. The new clubs will also require an increase in net working capital of \(\$ 1,500,000\) that will be returned at the end of the project. The tax rate is 40 percent, and the cost of capital is 14 percent. Calculate the payback period, the \(\mathrm{NPV}\), and the IRR.

Step by step solution

01

Calculate Cash Flows for Each Year

Compute cash flows for each year by considering the sales, variable costs, and fixed costs for each type of clubs. Also, add taxes and depreciation in the calculations. 1. Revenue from new clubs: \(70,000 \cdot 675 = \$ 47,250,000\) 2. Cost of new clubs: \(70,000 \cdot 340 = \$ 23,800,000\) 3. Lost Revenue from high-priced clubs: \(9,000 \cdot 1,100 = \$ 9,900,000\) 4. Lost Cost of high-priced clubs: \(9,000 \cdot 550 = \$ 4,950,000\) 5. Increase in Revenue from cheap clubs: \(12,000 \cdot 300 = \$ 3,600,000\) 6. Increase in Cost of cheap clubs: \(12,000 \cdot 100 = \$ 1,200,000\) 7. Depreciation of equipment: \(\frac{19,800,000}{7} = \$ 2,828,571.43\) Now, we'll use these calculations to compute the yearly cash flows.

02

Calculate Yearly Cash Flows Before Taxes

Calculate earnings before taxes using the numbers computed in step 1. Earnings before taxes for each year: \(EBT = \) (Revenue from new clubs - Cost of new clubs) - (Lost Revenue from high-priced clubs - Lost Cost of high-priced clubs) + (Increase in Revenue from cheap clubs - Increase in Cost of cheap clubs) - (Fixed Costs) - (Depreciation) \(EBT = (47,250,000 - 23,800,000) - (9,900,000 - 4,950,000) + (3,600,000 - 1,200,000) - (10,800,000) - 2,828,571.43\) \(EBT = \$ 7,844,228.57\)

03

Calculate Yearly Cash Flows After Taxes

Deduct taxes (40%) from the earnings before taxes, and add back the depreciation to determine the cash flows after taxes. \(EBAT = EBT \cdot (1 - Tax Rate) + Depreciation\) \(EBAT = 7,844,228.57 \cdot (1 - 0.40) + 2,828,571.43\) \(EBAT = \$ 8,035,537.14\)

04

Calculate Payback Period

Calculate the payback period using the net investment and the cash flows after taxes for each year. Net Investment (plant and equipment cost, net working capital not included as it is returned at the end of the project): \(\$ 19,800,000 + \$ 1,000,000 + \$ 150,000 = \$ 20,950,000\) Payback Period = \(\frac{Net Investment}{Yearly Cash Flow}\) Payback Period = \(\frac{20,950,000}{8,035,537.14}\) Payback Period ≈ 2.61 years

05

Calculate Net Present Value (NPV)

Calculate the NPV using the cost of capital (14%) and cash flows after taxes for each year. \(NPV = \sum_{t=1}^{7} \frac{EBAT}{(1 + r)^t} - Net Investment\) \(NPV = \frac{8,035,537.14}{(1+0.14)^1} + \frac{8,035,537.14}{(1+0.14)^2} + \dots + \frac{8,035,537.14}{(1+0.14)^{7}} - 20,950,000\) \(NPV ≈ \$ 16,450,169.09\)

06

Calculate Internal Rate of Return (IRR)

Since we don't have an analytical formula to calculate the IRR, we can use financial calculators or Excel's IRR function to find the IRR by using the net cash flow values for each year including the initial investment (with a negative sign). Alternatively, one could iterate discount rates until the NPV equals zero. Using Excel's IRR function: \(IRR(\{-20,950,000, 8,035,537.14, 8,035,537.14, 8,035,537.14, 8,035,537.14, 8,035,537.14, 8,035,537.14 + 1,500,000\})\) IRR ≈ 18.93% #Summary# - Payback Period: 2.61 years - Net Present Value (NPV): \$ 16,450,169.09 - Internal Rate of Return (IRR): 18.93%

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Investment Analysis

Investment analysis is the process of evaluating an investment's potential to generate returns. It involves calculating various financial metrics to understand the profitability and risks of a particular investment. McGilla Golf's decision to launch a new line of golf clubs requires such an analysis to ensure the project will be beneficial.

Analyzing investments involves several steps:

• Estimating potential revenues and costs: For McGilla Golf, this involves revenue from selling 70,000 new club sets and considering the offset by loss of sales from other product lines.
• Incorporating fixed and variable costs: These include the cost of production and ongoing operational expenses like labor and materials for the new clubs.
• Factoring in depreciation: Investment in plant and equipment can affect cash flows due to depreciation since it's a non-cash expense.

These components help assess whether the investment will likely return more than it costs, guiding whether or not to pursue the project.

Cash Flow Management

Cash flow management is essential for any business, as it ensures the company can meet its obligations and invest in future growth. In financial projects like McGilla Golf's, cash flow is analyzed to maintain liquidity while funding the project.

The cash flow for McGilla Golf's project includes:

• Revenue from sales of new clubs adjusted for lost sales and increased sales of other product lines.
• Subtracting variable and fixed costs related to production and operation.
• Considering tax obligations and non-cash expenditures such as depreciation.
• Accounting for changes in net working capital, crucial for operating activities and ensuring sufficient reserves to cover short-term liabilities.

Effective cash flow management allows a company like McGilla Golf to not only fund the initial investment but also maintain operations smoothly throughout the life of the project.

Net Present Value

Net Present Value (NPV) is a critical metric in investment analysis, representing the difference between the present value of cash inflows and outflows over time. It helps determine whether a project should proceed based on its ability to generate profit relative to its cost.

In the exercise, McGilla Golf's project NPV calculation involved:

• Estimating annual cash flows from the new golf club line.
• Discounting these cash flows back to their present value, using a discount rate equal to the cost of capital (14% in this scenario).
• Subtracting the initial investment from the total discounted future cash flows.

A positive NPV implies that McGilla Golf's project is expected to generate more cash than the cost, making it a worthwhile investment. With an NPV of approximately $16,450,169.09, this project looks promising for the company.

Internal Rate of Return

The Internal Rate of Return (IRR) is a metric used to evaluate the profitability of an investment. It is the discount rate at which the net present value of all cash flows from a project equals zero.

For McGilla Golf's investment:

• The IRR represents the efficiency and potential profitability of the project compared to the cost of capital.
• An IRR exceeding the cost of capital (14%) means the project is expected to add value to the firm.
• McGilla Golf's IRR of approximately 18.93% indicates a higher return than the cost threshold, suggesting the project could be financially beneficial.

Investors and management use IRR as part of their decision-making process to assess whether the project's returns are adequate compared to alternative investments.