Problem - Existing asset   Replacement problem   Problem # 1   Consider the following for an 8 year special revenue generating project.   (this is the...

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):

o   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? 

o   If Cost of Goods Sold were 75% of sales?