Case Scenario:
Congratulations! Your work on understanding and managing the costs and profitability of Lava Rocks cycles has resulted in record-breaking sales volume and profits. As a result, senior management is considering two proposals to expand the product line. Expansion of the product line requires a new facility and production team. Senior management hired a consulting firm to research the potential product lines. Lava Rocks would like to make this product line for at least 5 years (so the evaluation is for 5 years of revenues and costs). You were at a meeting with the researchers and they gave you the results of the research. Create a presentation that you will make to management. Use the following assumptions:
Assume the risk-adjusted cost of capital is 12%, compute net present value (NPV) for each proposal. Include the cash flows from salvage value and the tax benefits of depreciation (assume 5-year straight-line). Incorporate the research data and graphs and charts into your presentation for support to your recommendation.
Include in your presentation recommendations on the product line for senior management? Specify how your recommendation is affected by your assumptions for cost of capital and expected contribution margin (that is, perform a sensitivity analysis)?
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Proposal 1
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Proposal 2
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New product line
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Mid-level Mountain Bike
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Entry-level Hybrid Bike
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Estimated first year revenues
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$600,000
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$800,000
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Estimated annual revenue growth
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6%
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4%
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Estimated Contribution margin %
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40%
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45%
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Marginal Tax Rate (for tax benefit calculation)
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40%
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40%
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Estimated annual fixed costs
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$120,000
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$100,000
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Investment in Facility
(expected salvage in year 6 of $400,000)
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$1,500,000
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$1,275,000
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One-time advertising (year 0)
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$140,000
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$150,000
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Component inventory
(value returned in full in year 6)
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$150,000
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$125,000
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