human
Provide an essay for relevant cash flows for Sneaker 2013 and how they that can be used to calculate the net present value of the project.
assistant
##Sneaker 2013 and Persistence Case Analysis Case Study
Relevant cash flows for Sneaker 2013 are those that are directly associated with the project. Among such cash flows are sales of Sneaker 2013, variable costs, an increase in inventory, an increase in accounts payable, the cost of equipment that needs to be purchased and its installation, the cost of building a factory in Vietnam, the interest cost on debt which needs to be employed to finance the project, and the advertising and promotion costs. Tax expense is also a relevant cash flow as it concerns Sneaker 2013 project. The reduction in sales of existing New Balance shoes should be regarded as the lost revenue, which is also incremental cash flow. Even though the cost of equipment and its installation and the cost of real estate are depreciated, depreciation is not a cash flow. $2 million spent on research and development on Sneaker 2013 is a sunk cost that should be ignored.
Relevant cash flows for Persistence include revenue generated from sales, an increase in the working capital, the cost of equipment, the cost of the design technology and manufacturing specifications for a new hiking shoe, interest expense on debt, taxes, and net income after tax. The allocation of overheads associated with the use of the company’s factories is a sunk cost and not a component of relevant cash flows. There is no opportunity cost as the introduction of the product is not expected to impact the existing sales. Depreciation is a non-cash item, which is why it is not a relevant cash flow.
The net present value of a project can be calculated as the difference between the present value of future cash flows and the initial cost of investment. The initial cost of investment includes the cost of equipment and its installation (15 million in total), the cost of building a factory in Vietnam (150 million), and an increase in the working capital, which is equal to the difference between an increase in current assets and an increase in current liabilities. The initial cost of investment for Sneaker 2013 can be calculated as:
###Tables 1 and 2 show total cash flows and discounted cash flows for Sneaker 2013 for 2013-2018. Revenue was calculated by multiplying sales volume by net price. Gross profit was calculated by subtracting variable costs from revenue. Tax expense was calculated by multiplying the tax rate by income before taxes. Discounted cash flows were calculated using the following formula:
###Table 1. Cash Flows for Sneaker 2013.
                        2013    2014    2015    2016    2017    2018   
Revenue                    138000000 184000000 161000000 276000000 207000000 103500000
Gross profit                  62100000  82800000  72450000  124200000 93150000  46575000 
Selling, general, and administrative expenses 7000000  7000000  7000000  7000000  7000000  7000000 
Advertising expenses              2000000  2000000  2000000  3000000  2000000  2000000 
Other advertising expenses           25000000  15000000  10000000  30000000  25000000  15000000 
Interest expense                1200000  1200000  1200000  1200000  1200000  1200000 
Total depreciation (for tax purposes)     7900000  13900000  10850000  9150000  8650000  7200000 
Net income before tax             19000000  43700000  41400000  73850000  49300000  14175000 
Tax expense                  7600000  17480000  16560000  29540000  19720000  5670000 
Cash inflow                  19300000  40120000  35690000  53460000  38230000  15705000 
###Table 2. Discounted Cash Flows for Sneaker 2013.
                 Sneaker 2013
Cost of investment        175000000  
Discounted cash inflow – year 1 17387387,39 
Discounted cash inflow – year 2 32562292,02 
Discounted cash inflow – year 3 26096220,4 
Discounted cash inflow – year 4 35215757,88 
Discounted cash inflow – year 5 22687644,27 
Discounted cash inflow – year 6 8396534,331 
Net cash flows          142345836  
At the end of the project, the company will gain an additional 115,000,000 million if it sells the equipment and the factory and recovers the working capital. Thus, the NPV of the project is:
The lost revenue (or opportunity cost) is equal to the lost sales multiplied by the gross margin:
The IRR can be calculated by solving the following equation for R:
Using What-If analysis in Excel, the value of R is equal to 48.35%, which is the internal rate of return for Sneaker 2013.
The payback period is calculated by subtracting each individual annual cash inflow from the cost of investment until a positive amount is achieved. The payback period for Sneaker 2013 is equal to five years (see Table 3).
###Table 3. Cumulative Cash Flows for Sneaker 2013.
Year 0    Year 1    Year 2    Year 3   Year 4   Year 5 
(175000000) (155700000) (115580000) (79890000) (26430000) 11800000
The discounted payback period is calculated similarly to the payback period, yet the annual cash flows are discounted. The discounted payback period for Sneaker 2013 is equal to six years (see Table 4).
###Table 4. Cumulative Discounted Cash Flows for Sneaker 2013.
Year 0    Year 1    Year 2    Year 3   Year 4   Year 5   Year 6 
(175000000) (157612613) (125050321) (98954100) (63738342) (41050698) 82345836
Profitability index for Sneaker 2013 is equal to:
The initial cost of investment for Persistence includes the cost of manufacturing equipment (8 million) and an increase in the working capital (15 million). The initial cost of investment for Persistence is equal to:
###Tables 5 and 6 show total cash flows and discounted cash flows for Persistence for 2013-2015. Total sales were calculated by multiplying the total sales for the athletic footwear market by the market share projections for Persistence with consideration of the annual growth rate. The gross profit was calculated by subtracting variable costs from total sales. Purchase of intangible assets is recognized as an immediate expense, which is why it is not amortized. The tax expense was equal to zero in 2013 since the company did not generate any income.
###Table 5. Cash Flows for Persistence.
                        2013    2014   2015  
Sales                     52500000  72450000 92575000
Gross profit                  32550000  44919000 57396500
Selling, general, and administrative expenses 3906000   4491900  4591720 
Advertising expenses              3000000   2000000  2000000 
Interest expense                600000   600000  600000 
Purchase of intangible assets         50000000           
Tax expense                  0      14106840 19473912
Cash inflow (outflow)             (24956000) 23720260 33050868
###Table 6. Discounted Cash Flows for Persistence.
                 Persistence
Cost of investment        23000000  
Discounted cash outflow – year 1 (21891228) 
Discounted cash inflow – year 2  18251969,8 
Discounted cash inflow – year 3  22308394,5 
Net cash flows          18669136  
At the end of the project, the company will gain an additional 17,320,000 if it sells the equipment and recovers the working capital. Thus, the NPV of the project is:
Using What-If analysis in Excel, the value of R is equal to 42%, which is the internal rate of return for Persistence.
The payback period for Persistence is equal to three years (see Table 7).
###Table 7. Cumulative Cash Flows for Persistence.
Year 0   Year 1   Year 2   Year 3 
(23000000) (47956000) (24235740) 26135128
The discounted payback period is equal to three years (see Table 8).
###Table 8. Discounted Cumulative Cash Flows for Persistence.
Year 0   Year 1   Year 2   Year 3   
(23000000) (44891228) (26639258) 12989136,25
Profitability index for Persistence is equal to:
###Tables 9 and 10 show the capital budgeting cash flow statements for Sneaker 2013 and Persistence, respectively.
###Table 9. Projected Capital Budgeting Cash Flow Statement for Sneaker 2013 for 2013-2018.
Year                      0     1      2      3      4      5      6     
Beginning cash flows                                                        
Real estate                  (150m)                                        
Equipment                   (15m)                                        
Working capital                (10m)                                        
Total                     (175m)                                        
Operating cash flows                                                        
Volume of sales                     1200000   1600000   1400000   2400000   1800000   900000   
Sale price                        190     190     190     190     190     190    
Cash revenue                       138000000  184000000  161000000  276000000  207000000  103500000 
Gross profit                       62100000   82800000   72450000  124200000  93150000   46575000  
Selling, general, and administrative expenses      7000000   7000000   7000000   7000000   7000000   7000000  
Advertising expenses                   2000000   2000000   2000000   3000000   2000000   2000000  
Other advertising expenses                25000000   15000000   10000000  30000000   25000000   15000000  
Operating income                     28100000   58800000   53450000  84200000   59150000   22575000  
Interest expense                     1200000   1200000   1200000   1200000   1200000   1200000  
Depreciation of equipment                4000000   6400000   3800000   2400000   2200000   1200000  
Depreciation of property                 3900000   7500000   7050000   6750000   6450000   6000000  
Total depreciation                    7900000   13900000   10850000  9150000   8650000   7200000  
Income before tax                    19000000   43700000   41400000  73850000   49300000   14175000  
Tax expense (40%)                    7600000   17480000   16560000  29540000   19720000   5670000  
Net income after tax                   19300000   40120000   35690000  53460000   38230000   15705000  
Present value CF                     17387387,39 32562292,02 26096220,4 35215757,88 22687644,27 8396534,331
Net present value               82345836                                       
###Table 10. Projected Capital Budgeting Cash Flow Statement for Persistence for 2013-2015.
Year                      0     1       2      3     
Beginning cash flows                                      
Equipment                   (8m)                       
Working capital                (15m)                      
Total                     (23m)                      
Operating cash flows                                      
Sales                          52500000    72450000   92575000  
Gross profit                       32550000    44919000   57396500  
Selling, general, and administrative expenses      3906000    4491900   4591720  
Advertising expenses                   3000000    2000000   2000000  
Purchase of intangible assets              50000000                
Operating income (loss)                 (24356000)   38427100   50804780  
Interest expense                     600000     600000    600000   
Depreciation of equipment                1600000    2560000   1520000  
Income (loss) before tax                 (26556000)   35267100   48684780  
Tax expense (40%)                    0       14106840   19473912  
Net income (loss) after tax               (24956000)   23720260   33050868  
Present value CF                     (21891228,07) 18251969,84 22308394,49
Net present value               12989136                     
Sneaker 2013 can be considered a more attractive choice for New Balance shareholders because it offers a higher return on the initial investment and has a greater net present value. Even though the implementation of Sneaker 2013 entails the revenue loss, which is equal to 20 million, this project is expected to generate more positive cash flows, compared to Persistence. On the other hand, Persistence is a good option, too, because its profitability index is slightly higher and its net present value is positive. However, the main reason why Persistence is worse than Sneaker 2013 is that it has a too high cost of intangible assets that should be purchased immediately.
Based on all the above-said, Rodriguez may be recommended to undertake Sneaker 2013. Despite the fact that this project is slightly less profitable, its internal rate of return and net present value are much higher. If the company found a way to minimize costs associated with the purchase of the design technology or the project had a longer life cycle, Persistence could be a more feasible choice. As for now, however, shareholders will gain more from Sneaker 2013 than from Persistence.