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Question 1

Stream of Free Cash Flows

Lopez Toy is a famous company for standard dolls.It was proposed by Luis Rivera that it has a chance to enter into the designer doll market. The designer dolls market is a high quality market with higher margin. Before entering into that segment, they decided to conduct a preliminary search from a consultant.

The consultant analyzed that Lopez toys can sell its designer doll for 40 dollars each. He also analyzed that the price of each doll will remain 40 dollars for next five years.Therefore,in the calculations performed under the analysis that were suggested by the consultant, a certain number of cash flows occurred. Firstly, the new equipment will be required for the purpose of launching new dolls and it will cost 2000,000 dollars to Lopez Toys.

According to the consultant, the life of the machine will be from five to ten years. Therefore, the NPV calculations are performed for both five years and ten years. It is expected that the monthly demand for the designer dolls will be 3,000, therefore by multiplying the monthly demand with the number of months and with the selling price,the revenue per year is calculated,which is 1,440,000 dollars.

The resale value of the equipment is 100,000 dollars at the end of the project there fore the resale or residual value of the equipment is incorporated in the calculation of both NPVs with respected life of the equipment. There are a number of cash outflows as per the analysis performed by the consultant.

It is expected that the amount of finished goods and work in progress inventory will be 20000, therefore by multiplying this value by three the annual inventory level is found, which is 60,000. By multiplying with the material cost, which is 10 dollars per doll, the annual cost upon designer dolls is calculated,which is 600,000 dollars.

According to the analysis performed by the consultant, the labor cost will be 12,000 dollars per month; therefore by multiplying the labor cost with the number of months, the annual labor cost is calculated.Similarly, the energy cost for three years is calculated and it is expected to be 36000 dollars per year.

The consult antcharged 70,000 dollars for his services, although it is performed before taking the project, how ever it is conducted for the analysis of the project and the fee is supposed to be paid after one month.As a result,the consultant fee is also incorporated into the NPV calculations. It will incur once at the start of the project, which is why it is incorporated only in the year 1.

The place where this equipment is installed was rented and the company received 10,000 dollars per year from the rental income. After the installation of the equipment, its rental income will discontinue throughout the life of the project, which is why it is incorporated as an out flow because it is an opportunity loss.

It is expected that the equipment will depreciate according to the straight line method and will be calculated upon the useful life of the equipment, which is 400,000 dollars in the case of 5 years NPV calculations and 200,000 dollars in the case of 10 years NPV calculations.

According to the analysis by consultant, the tax rate will be 40% and net cash flows will charge tax outflow or inflow at this rate. Lopez toy will also receive tax savings upon equipment’s deprecation, which will be different for 5 years and 10 years.

It is also expected that certain other after tax cash flows will also occur like the loss of 80000 dollars upon standard dolls is expected to be occurring due to the sale of designer dolls and this loss will reduce the after tax cash flows with 8000 dollars. The management of the company decided that 1% of the annual revenue will be charged to the after tax cash flows in order to cover the overhead head cost.The Premium Project Case Solution

They also decided that 10% of the book value of the asset will be charged to after tax cash flows for the purpose to deduct a finance charge, which upon finance, is used in the purchase of the equipment. This finance charge will be different each year because the book value of the equipment will also be different due to the depreciation. Each year’s depreciation will reduce the book value of the equipment.................................

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