Through careful research; you expect that after the runaway success of the movie “Black Tiger”--and acknowledging the broad appeal of kitten videos on YouTube--XYZ will invest heavily in a series of “Black Kitten” theme park rides going forward. You expect the new attraction to generate sales of $10 billion in its first year, and $5 billion in sales in the second year. Sales are expected to remain unchanged between the second and third years because of market saturation. Thereafter, you expect annual sales to decline to two-thirds of peak annual sales in the fourth year; and one-third of peak sales in the fifth year. For the new product, you expect no material levels of revenues and expenses after five years of sales. Based on historical data, the cost of sales for the new attractions is expected to be 70% of total annual sales revenue during each year of its life cycle. You expect selling, general, and administrative expenses to be 16.5% of total annual sales. Taxes on profits generated by the new attraction would be paid at a 21% rate.
To launch the new attraction, XYZ would have to incur immediate cash outlays of two types: First it would have to invest $25 million in specialized production equipment. This capital investment would be fully depreciated on a straight-line basis over the five-year anticipated life cycle of the new attraction. You do not expect the equipment to have a material salvage value at the end of the depreciable life. No further fixed capital expenditures will be required after the initial purchase of the equipment. Second, XYZ will invest in net working capital to support sales. For this type of business, 25 cents of net working capital is required to support each dollar of sales. As a practical matter, this buildup will be made by the beginning of the sales year in question (or equivalently, by the end of the previous year). As the company experiences sales growth, further investments in net working capital will be made ahead of sales. As sales diminish, net working capital will be liquidated and cash recovered. At the end of the new attraction’s life cycle, all remaining net working capital will be liquidated and the cash recovered.
Finally, XYZ is expected to incur tax–deductible introductory expenses of $15 million in the first year of the new attraction’s sales. These costs will not be recurring over the new attraction’s life cycle. Approximately $50 million has already been spent in developing the new attraction. These expenditures are one-time expenses that will not be recurring over the new attraction’s life cycle.
Estimate the weighted average cost of capital for XYZ’s new attraction.
Estimate the new attraction’s future sales, profits, and cash flows for its five-year life.
What is the net present value for the new attraction? What is its internal rate of return? (Apart from changes in net working capital, which must be made before the start of each sales year, you should assume that all cash flows occur at the end of the year in question.)
Should XYZ introduce the new attraction?