Accept or reject a new product line:
Mac Linden Brothers Electronics Canadian branch is considering introducing into the North American market the just developed new electronic device which, when mounted on an automobile, will allow the automobile to self-drive, using radar and computer control. The device can be mounted on any model of automobile in a few minutes time for negligible cost.
The company is anxious to begin production and distribution of the new device. To this end, marketing and cost studies have been made to determine probable costs and market potential. These studies have provided the following information:
A. New stamping and electronics equipment would have to be acquired in order to produce the device. The stamping equipment would cost $3,500,000 and have a 12-year useful life. After 12 years, the stamping equipment would have a salvage value of 1% of its original cost. The electronic equipment has an initial cost of $2,750,000 and also has a 12-year useful life. After 12 years, the electronic equipment will have no salvage value.
B. Sales in units over the next 12 years are calculated according to the sales budget formula which is:
1. Sales in year 1 are estimated to be 10,000 units.
2. Production and sales each year thereafter is estimated to be the yearly percentage increase or decrease of sales using the previous year’s sales as a base.
3. Sales in years 2 and 3 are estimated to be 110% of the previous year’s sales.
4. Sales in years 4 through 6 are estimated to be 120% of the previous year’s sales.
5. Sales in years 7 through 9 are estimated to be 90% of the previous year’s sales.
6. Sales in years 10 through 12 are estimated to be 60% of the previous year’s sales.
Production and sales of the device would require working capital of $120,000 in order to finance accounts payable, inventories and day-to-day cash need. The unused portion of the working capital would be released back to the company at the end of the project’s life.
C. The devices would sell for $240 each; variable costs of production, administration and sales would be $35 per unit.
D. Fixed costs are as follows:
1. Salaries: Supervisor $65,000/year. A $5,000 raise is scheduled if the same supervisor is still on the job after year 6. Assume that she will be.
2. Employee’s salaries will total $85,000/year.
2. Maintenance: $27,500/year.
3. Property taxes: $17,500/year.
4. Utilities expense (fixed):$60,000/year
5. Insurance would total $10,000 per year.
6. Miscellaneous fixed expenses total $6,000/year
E. MACRS depreciation is to be used, and the equipment will be depreciated using MACRS percentages under the 7-year class. (Depreciation is based on original cost times the MACRS depreciation % per year, using the half-year convention: Yr1 = 14.29%; Yr2 = 24.49%; Yr3 = 17.49%; yr4 = 12.49%; Yr5 = 8.93%; Yr6 = 8.92%; Yr7 = 8.93% and Yr8 = 4.46%). No depreciation would be taken after year 8. MACRS depreciation will be deducted from Net Income before Tax to calculate Taxable Income, and then added back in to calculate Cash Flows after Taxes.
F. An overhaul of the stamping equipment will be necessary during year 4 and again during year 8. These overhauls are expected to cost $40,000 each and will be paid for out of the working capital funds.
G. In order to gain rapid entry into the market, the company would have to advertise heavily. The advertising program would cost:
Years 1-2………………………………. $250,000 per year
Year 3………………………………….. 200,000 per year
Years 4-12…………………………….. 80,000 per year
The advertising funds thus expensed are considered to be fixed costs within the year they are spent.
H. Mac Linden Bros. Electronics Board of Directors has specified that all new product lines must promise a return of at least 20%, which is the cost of capital for this project. In addition, the project must be acceptable under Canadian law as well.
I. The average income tax rate to use in this analysis is 40%.
Required: (label each answer prominently)
1. EXCEL formulas must be used for all calculations on the spreadsheet, except for the interpolation which may be worked on a calculator. Calculations not supported by EXCEL formulas will not be accepted. Use accounting formatting, which will have parenthesis “()” around negative numbers. Negative numbers should be displayed in red. Round all units to the nearest whole unit, and all dollar amounts to the nearest whole dollar, using the $ sign.
2. Compute the net cash flow (cash receipts less yearly cash operating expenses) anticipated from the sale of the device for each of the 12 years. Include the start-up costs in year 0.
3. Using data from 1 above and other data in the problem, determine the net present value (NPV) of the proposed investment for costs of capital from 20% to 26%. Use the factors given in the handout.
4. Compute the internal rate of return (IRR) for the project using interpolation of uneven cash flows.
5. State clearly for management’s benefit in professional terms whether the project should be accepted or rejected. Why or why not?