The real discount rate for Sony is 8 percent. Calculate the NPV of this project.

37. Project Analysis and Inflation After extensive medical and marketing research, Pill, Inc.,
believes it can penetrate the pain reliever market. It is considering two alternative products. The
first is a medication for headache pain. The second is a pill for headache and arthritis pain. Both
products would be introduced at a price of $5.25 per package in real terms. The headache-only
medication is projected to sell 4 million packages a year, whereas the headache and arthritis
remedy would sell 6 million packages a year. Cash costs of production in the first year are expected
to be $2.45 per package in real terms for the headache-only brand. Production costs are expected
to be $2.75 in real terms for the headache and arthritis pill. All prices and costs are expected to
rise at the general inflation rate of 5 percent.

Either product requires further investment. The headache-only pill could be produced using
equipment costing $15 million. That equipment would last three years and have no resale value.
The machinery required to produce the broader remedy would cost $21 million and last three years.
The firm expects that equipment to have a $1 million resale value (in real terms) at the end of year
3.

Pill, Inc., uses straight-line depreciation. The firm faces a corporate tax rate of 34 percent and
believes that the appropriate real discount rate is 13 percent. Which pain reliever should the firm
produce?

38. Calculating Project NPV J. Smythe, Inc., manufactures fine furniture. The company is
deciding whether to introduce a new mahogany dining room table set. The set will sell for $5,600,
including a set of eight chairs. The company feels that sales will be 1,800, 1,950, 2,500, 2,350, and
2,100 sets per year for the next five years, respectively. Variable costs will amount to 45 percent of
sales, and fixed costs are $1.9 million per year. The new tables will require inventory amounting to
10 percent of sales, produced and stockpiled in the year prior to sales. It is believed that the
addition of the new table will cause a loss of 250 tables per year of the oak tables the company
produces. These tables sell for $4,500 and have variable costs of 40 percent of sales. The inventory
for this oak table is also 10 percent of sales. J. Smythe currently has excess production capacity. If
the company buys the necessary equipment today, it will cost $16 million. However, the excess
production capacity means the company can produce the new table without buying the new
equipment. The company controller has said that the current excess capacity will end in two years
with current production. This means that if the company uses the current excess capacity for the
new table, it will be forced to spend the $16 million in two years to accommodate the increased
sales of its current products. In five years, the new equipment will have a market value of $3.1
million if purchased today, and $7.4 million if purchased in two years. The equipment is depreciated
on a seven-year MACRS schedule. The company has a tax rate of 40 percent, and the required
return for the project is 14 percent.

1. Should J. Smythe undertake the new project?

2. Can you perform an IRR analysis on this project? How many IRRs would you expect to
find?

3. How would you interpret the profitability index?

Mini Cases: BETHESDA MINING COMPANY

Bethesda Mining is a midsized coal mining company with 20 mines located in Ohio, Pennsylvania,
West Virginia, and Kentucky. The company operates deep mines as well as strip mines. Most of the coal
mined is sold under contract, with excess production sold on the spot market.

The coal mining industry, especially high-sulfur coal operations such as Bethesda, has been hard-hit
by environmental regulations. Recently, however, a combination of increased demand for coal and new
pollution reduction technologies has led to an improved market demand for high-sulfur coal. Bethesda
has just been approached by Mid-Ohio Electric Company with a request to supply coal for its electric
generators for the next four years. Bethesda Mining does not have enough excess capacity at its existing
mines to guarantee the contract. The company is considering opening a strip mine in Ohio on 5,000
acres of land purchased 10 years ago for $6 million. Based on a recent appraisal, the company feels it
could receive $7 million on an aftertax basis if it sold the land today.

Strip mining is a process where the layers of topsoil above a coal vein are removed and the exposed
coal is removed. Some time ago, the company would simply remove the coal and leave the land in an
unusable condition. Changes in mining regulations now force a company to reclaim the land; that is,
when the mining is completed, the land must be restored to near its original condition. The land can then
be used for other purposes. Because it is currently operating at full capacity, Bethesda will need to
purchase additional necessary equipment, which will cost $85 million. The equipment will be depreciated
on a seven-year MACRS schedule. The contract runs for only four years. At that time the coal from the
site will be entirely mined. The company feels that the equipment can be sold for 60 percent of its initial
purchase price in four years. However, Bethesda plans to open another strip mine at that time and will
use the equipment at the new mine.

The contract calls for the delivery of 500,000 tons of coal per year at a price of $95 per ton.
Bethesda Mining feels that coal production will be 620,000 tons, 680,000 tons, 730,000 tons, and
590,000 tons, respectively, over the next four years. The excess production will be sold in the spot
market at an average of $90 per ton. Variable costs amount to $31 per ton, and fixed costs are
$4,300,000 per year. The mine will require a net working capital investment of 5 percent of sales. The
NWC will be built up in the year prior to the sales.

Bethesda will be responsible for reclaiming the land at termination of the mining. This will occur in
year 5. The company uses an outside company for reclamation of all the company’s strip mines. It is
estimated the cost of reclamation will be $2.8 million. After the land is reclaimed, the company plans to
donate the land to the state for use as a public park and recreation area. This will occur in year 6 and
result in a charitable expense deduction of $7.5 million. Bethesda faces a 38 percent tax rate and has a
12 percent required return on new strip mine projects. Assume that a loss in any year will result in a tax
credit.

You have been approached by the president of the company with a request to analyze the project.
Calculate the payback period, profitability index, average accounting return, net present value, internal
rate of return, and modified internal rate of return for the new strip mine. Should Bethesda Mining take
the contract and open the mine?

GOODWEEK TIRES, INC.

After extensive research and development, Goodweek Tires, Inc., has recently developed a new tire,
the SuperTread, and must decide whether to make the investment necessary to produce and market it.
The tire would be ideal for drivers doing a large amount of wet weather and off-road driving in addition
to normal freeway usage. The research and development costs so far have totaled about $10 million. The
SuperTread would be put on the market beginning this year, and Goodweek expects it to stay on the
market for a total of four years. Test marketing costing $5 million has shown that there is a significant
market for a SuperTread-type tire.

As a financial analyst at Goodweek Tires, you have been asked by your CFO, Adam Smith, to
evaluate the SuperTread project and provide a recommendation on whether to go ahead with the
investment. Except for the initial investment that will occur immediately, assume all cash flows will occur
at year-end.

Goodweek must initially invest $140 million in production equipment to make the SuperTread. This
equipment can be sold for $54 million at the end of four years. Good-week intends to sell the
SuperTread to two distinct markets:

1. The original equipment manufacturer (OEM) market: The OEM market consists primarily of the
large automobile companies (like General Motors) that buy tires for new cars. In the OEM market,
the SuperTread is expected to sell for $38 per tire. The variable cost to produce each tire is $22.

2. The replacement market: The replacement market consists of all tires purchased after the
automobile has left the factory. This market allows higher margins; Goodweek expects to sell the
 SuperTread for $59 per tire there. Variable costs are the same as in the OEM market.

Goodweek Tires intends to raise prices at 1 percent above the inflation rate; variable costs will also
increase at 1 percent above the inflation rate. In addition, the SuperTread project will incur $26 million in
marketing and general administration costs the first year. This cost is expected to increase at the
inflation rate in the subsequent years.

Goodweek’s corporate tax rate is 40 percent. Annual inflation is expected to remain constant at 3.25
percent. The company uses a 15.9 percent discount rate to evaluate new product decisions. Automotive
industry analysts expect automobile manufacturers to produce 5.6 million new cars this year and
production to grow at 2.5 percent per year thereafter. Each new car needs four tires (the spare tires are
undersized and are in a different category). Goodweek Tires expects the SuperTread to capture 11
percent of the OEM market.

Industry analysts estimate that the replacement tire market size will be 14 million tires this year and
that it will grow at 2 percent annually. Goodweek expects the SuperTread to capture an 8 percent
market share.

The appropriate depreciation schedule for the equipment is the seven-year MACRS depreciation
schedule. The immediate initial working capital requirement is $9 million. Thereafter, the net working
capital requirements will be 15 percent of sales. What are the NPV, payback period, discounted payback
period, IRR, and PI on this project?