Exercise 1: LG Electronics (Part 1)
LG Electronics is a midsized reputable manufacturer of various electronic items. LG spent $750,000 to develop a prototype for a new TV SET-UP BOX that has all the features of the existing TV SET-UP BOX v0 but adds new features and a further $200,000 for a marketing study to determine the expected sales figures for the new device. This new model will replace immediately the existing one, which will not be sold after LG launches the new TV SET-UP BOX. LG can manufacture the new TV SET-UP BOX for $150/unit in variable costs. Fixed costs for the operations are estimated to run $4.5 million per year. The annual estimated sales volume is 70,000, 80,000, 100,000, 85,000, and 75,000 fir the next five years. The price of the new TV SET-UP BOX will be $340/unit and the necessary equipment can be purchased for $16.5 million and will be depreciated on a seven-year schedule.
No residual value is expected at the end of year 5. Net working capital for the TV SET-UP BOXs will be 20 percent of sales and will occur with the timing of the cash flows for the year. LG has a 35 percent corporate tax rate (taxes are paid in the year in which they are accrued) and a debt/equity ratio of 0.5. One month ago, LG raised 20 MM $ of debt at a 5% rate.The current risk free rate is 3%, the market premium is 6% and beta of similar companies to LG but with no debt is 1.3. You have been recently hired by the investment analysis department and the CEO asks you to prepare a report that answers the following questions:
1. What is the current cost of capital?
2. What is the payback period of the project?
3. What is the IRR of the project?
4. What is the NPV of the project?
5. What is your recommendation?
Exercise 2: LG2 Electronics (Part 2)
Imagine that, instead of being immediately fully replaced, production and sales of the existing model TV SET-UP BOX v0 continue two more years. The investments needed to manufacture this product have already been amortized and fixed costs are $1,800,000 per year. If LG does not introduce the new TV SET-UP BOX, sales of existing TV SET-UP BOX v0 will be 80,000 and 60,000 units for the next two years, respectively. The price of the existing TV SET-UP BOX v0 is $280/unit, with variable costs of $120/unit. If LG does introduce the new TV SET-UP BOX, sales of the existing TV SET-UP BOX v0 will fall by 30,000 units per year, and the price will have to be lowered to $140/unit. How would your analysis change?