Question

3. McGilla Golf is deciding whether to sell a new line of golf clubs. These clubs will sell for $825 per set and have a variable cost of $370 per set. The company has spent $150,000 for a marketing study which estimated that McGilla will sell 74,000 sets per year for seven years. The market study also concluded that this new line of clubs will cannibalize sales of their existing high-priced clubs to the amount of 8,900 few sets of high-priced clubs sold per year. The high-priced clubs sell for $1250 per set and have variable costs of $630 per set. Fixed operating costs will be $14,350,000 per year. The company has already spent $1,000,000 on research and

development costs for the new clubs. The plant and equipment required for the project will cost $29,400,000 and will fall into the MACRS 5-year class for depreciation (annual depreciation rates provided below). The equipment is expected to be worthless at the end of the project. The new clubs will require an initial investment in working capital of $3,500,000. The tax rate is 40%, and the required rate of return for the project is 14%.

Year	MACRS 5-year class Depreciation Rate
1	20.0%
2	32.0%
3	19.2%
4	11.5%
5	11.5%
6	5.8%

1. Compute free cash flows for all years of the project. Provide detail on your calculations and label all values.

2. Compute the NPV and IRR of the project.

3. Should McGilla Golf go ahead with this new line of golf clubs?

4. Are there any items presented in the narrative of this problem which should be ignored in your analysis? If

   so, why are they ignored?

Answer 1

F G N H I Operating Depreciation cash flows Tax@40% PAT 2 3 - X V fc =IRR(L2:19) A B C D E Relevant Depreciatio Year contribution Fixed costs PBT 0 1 28,152,000 14,350,000 5,880,000 7,922,000 28,152,000 14,350,000 9,408,000 4,394,000 3 28,152,000 14,350,000 5,644,800 8,157,200 4 28,152,000 14,350,000 3,381,000 10,421,000 5 28,152,000 14,350,000 3,381,000 10,421,000 6 28,152,000 14,350,000 1,705,200 12,096,800 7 28,152,000 14,350,000 - 13,802,000 2 3,168,800 1,757,600 3,262,880 4,168,400 4,168,400 4,838,720 5,520,800 4,753,200 2,636,400 4,894,320 6,252,600 6,252,600 7,258,080 8,281,200 5,880,000 9,408,000 5,644,800 3,381,000 3,381,000 1,705,200 10,633,200 12,044,400 10,539,120 9,633,600 9,633,600 8,963,280 8,281,200 J K L M Total cash PVIF@ NWC Investment flows 14% (3,500,000) (29,400,000) (32,900,000) 1.000 10,633,200 0.877 12,044,400 0.769 10,539,120 0.675 9,633,600 0.592 9,633,600 0.519 8,963,280 0.456 3,500,000 11,781,200 0.400 Cumulative cash flows (32,900,000) 9,327,368 9,267,775 7,113,606 5,703,865 5,003,390 4,083,550 4,708,207 IRR 25.78% NPV 12,307,760 13 14 Contribution from sale of golf club sales 15 Less: Contribution from loss sale of high priced clubs 16 17 Relevant contribution 18 $ 33,670,000 $ 5,518,000 = 74000* (825-370) =8900*(1250-630) 28,152,000 19 NPV > $0. McGilla should go ahead with new line of clubs 20 21 Marketing study cost is sunk cost. Sunk costs are irrelevant for decision making.

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