Pretty Kitty Supplies (PKS) is based in Bethesda, Ohio and has manufactured and sold cat toys, litter boxes, and related items for the past 60 years. The company has the opportunity to manufacture and market a new line of premium cat toys. As an employee of the company, you have been asked to analyze the project. The Project: PKS is trying to determine whether to license, manufacture and sell a new line of premium cat toys. The toys are designed to create a more interactive experience for cute kitties.
An evaluation of the project has estimated that sales will be $1.3 million, $1.6 million, $1.9 million, $2.2 million, and $2.4 million per year over the next five years, respectively. Variable costs of production for the new toy are 34 percent of sales. As was mentioned, PKS will be licensing the new toy designs from another company, Wonderful Kitty. The original owner of that company appeared on Shark Tank and struck a deal with Mr. Wonderful. In the negotiations for license, Mr. Wonderful said they would require a 6 percent licensing fee be paid to Wonderful Kitty per dollar of sales of the new product in perpetuity. Management has determined that the necessary equipment will cost $3.75 million and will be depreciated on a 15-year MACRS schedule. The new toys will require an investment of 15 percent of current year’s total sales in NWC each year. The NWC requirement is the same for all products manufactured by PKS. Fixed costs will be $275,000 per year. An outside consultant, who was hired at a cost of $75,000, has determined that the company will lose sales of $110,000, $120,000, $130,000, $130,000, and $140,000 from its existing cat toys year over the next five years, respectively. The existing cat toys have a variable cost equal to 32 percent of sales and fixed costs of $325,000 per year.
Other Issues: PKS believes that the cash flows from the new product line will grow at an annual rate of 2.2 percent for the indefinite future after Year 5. PKS has a capital structure of 25 percent debt. The floatation costs of debt are 3 percent and the floatation costs of equity are 6 percent. The company finances 80 percent of the equity of new project using retained earnings. Net working capital does not require floatation costs. At the beginning of the negations, PKS paid $150,000 for the option to choose whether to manufacture the new toys for the next two years. This means that PKS can decide whether to manufacture the new toys any time over the next two years but no other company can manufacture the new toys during this time. However, if PKS decides not to license the toys in the next two years, Wonderful Kitty is free to go to any other company. If this happens, PKS will lose projected sales of $110,000, $125,000, and $140,000 of its current cat toys in Years 3 through 5 to the competitor that introduces the new cat toy line. The tax rate for PKS is 38 percent. The hurdle rate for the new toy line is 10.1 percent. Analysis: Calculate the payback period, profitability index, NPV and IRR.