1. Pointless Luxuries Inc. (PLI) produces unusual gifts targeted at wealthy consumers. The company is analyzing the introduction of a new device designed to attach to the collar of a cat or dog. The product contains a GPS, an audible that can be triggered remotely, and an automatic emergency K-911 number that is called if the animal is injured. PLI estimates that developing this product will require up-front capital expenditures of $10 million, costs that will be depreciated on a straight-line basis to zero over five years. However, PLI estimates they could sell the equipment at the end of five years for $3,000,000. The project would use an existing warehouse that you own that is currently rented out to a neighboring firm. Next year’s rental charge on the warehouse is $200,000 and the rent is expected to grow at 4% a year. PLI believes that it can sell the product initially for $170. The selling price will increase to $190 in years 2 and 3 before falling to $170 and $150 in years 4 and 5, respectively. After five years the company will withdraw the product from the market and replace it with something else. Variable costs are $75 in year 1 and increase at an annual rate of 10%. PLI forecasts volume of 25,000 units the first year with subsequent increases of 25% (year 2), 20% (year 3), 20% (year 4), and 15% (year 5). Offering this product will force PLI to make additional investments in receivables and inventory. Projected end-of-year balances appear in the following table.
Year 0 1 2 3 4 5
Accounts Receivable $0 $100,000 $150,000 $200,000 $100,000 $0
Inventory $0 $300,000 $350,000 $400,000 $200,000 $0

The firm faces a tax rate of 34%.
a. Calculate the project’s cash flows each year.
b. Calculate the NPV assuming a 10% opportunity cost of capital. What is the cost of capital is 15%?
c. What is the IRR of the investment?

2. A bicycle manufacturer currently produces 300,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $250,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposes using a 10-year straight-line depreciation schedule. Expected proceeds from scrapping the machinery after 10 years are $20,000. The plant manager estimates that the operation would require additional working capital of $50,000 at the outset of the project but argues that this sum can be ignored since it will be recoverable at the end of 10 years. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

1. Pointless Luxuries Inc. (PLI) produces unusual gifts targeted at...