Zither, Inc. has stumbled on a catchy new product. It recognizes that the product will be a fad, and as such will not continue to generate sales in the long run, but it wants your assessment of whether it should proceed anyway. Zither recently hired a consulting firm at a cost of $400,000. The consulting firm’s report indicates that Zither could anticipate selling 3,700, 4,000, 3,500, and 1,700 units over the upcoming four years, all at a premium price of $600 per unit. For simplicity assume that collections (as well as production costs and expenses) occur at the end of each year. It may also be relevant to note that Zither has many other product lines that generate millions of dollars per year in profits.
The project would involve fixed production costs of $425,000 per year, as well as selling and administrative expenses equal to 13% of sales. In addition, Zither would have to invest $400,000 in working capital right away, though it would expect to recover the working capital at the end of the project. Production equipment would also have to be acquired right away, at a cost of $4.4 million. The equipment would be depreciated according to the 3-year MACRS schedule, and would have a salvage value of $800,000.
Zither acquired land that would be suitable for the production facilities two years ago, at a price of $1 million. The current after-tax value of the land is $800,000, and Zither’s best estimate is that the land value will remain stable from here. Zither’s tax rate for ordinary income and capital gains is 21%, and it has determined that a 12% discount rate is appropriate.
a. Compute the incremental cash flows that would result from a decision to proceed with the product.
b. Compute the project’s NPV.