Net Present Value Analysis of a New Product
Clarion Company is considering an opportunity to produce and sell a revolutionary new smoke detector for homes. To determine whether this would be a profitable venture, the company has gathered the following data on probable costs and market potential:
a. New equipment would have to be acquired to produce the smoke detector. The equipment would cost $100,000 and be usable for 12 years. After 12 years, it would have a salvage value equal to 10% of the original cost.
b. Production and sales of the smoke detector would require a working capital investment of $40,000 to finance accounts receivable, inventories, and day-to-day cash needs. This work- ing capital would be released for use elsewhere after 12 years.
c. An extensive marketing study projects sales in units over the next 12 years as follows:
|
Year(s)
|
Sales in Units
|
|
1
|
4,000
|
|
2
|
7,000
|
|
3
|
10,000
|
|
4-12
|
12,000
|
d. The smoke detectors would sell for $45 each; variable costs for production, administration, and sales would be $25 per unit.
e. To gain entry into the market, the company would have to advertise heavily in the early years of sales. The advertising program follows:
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Year(s)
|
Amount of Advertising
|
|
1-2
|
$70,000
|
|
3
|
50,000
|
|
4-12
|
40,000
|
f. Other fixed costs for salaries, insurance, maintenance, and straight-line depreciation on equipment would total $127,500 per year. (Depreciation is based on cost less salvage value.)
g. The company's required rate of return is 20%.
Required:
Ignore income taxes.
1. Compute the net cash inflow (cash receipts less yearly cash operating expenses) antici- pated from sale of the smoke detectors for each year over the next 12 years.
2. Using the data computed in (1) above and other data provided in the problem, determine the net present value of the proposed investment. Would you recommend that Clarion Company accept the smoke detector as a new product?