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.
Table 2. Discounted Cash Flows for Sneaker 2013.
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.
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.
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.
Table 6. Discounted Cash Flows for Persistence.
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.
The discounted payback period is equal to three years (see Table 8).
Table 8. Discounted Cumulative Cash Flows for Persistence.
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.
Table 10. Projected Capital Budgeting Cash Flow Statement for Persistence for 2013-2015.
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.