National Foods is considering producing a new candy, Nasty-As- Can-Be. National has spent two years and $450,000 developing this product. National has also test marketed Nasty, spending $100,000 to conduct consumer surveys and tests of the product in 25 states.
Based on previous candy products and the results in the test marketing, management believes consumers will buy 4 million packages each year for ten years at 50 cents per package. Equipment to produce Nasty will cost National $1,000,000, and $300,000 of additional net working capital will be required to support Nasty sales. National expects production costs to average 60% of Nasty’s net revenues, with overhead and sales expenses totaling $525,000 per year. The equipment has a life of ten years, after which time it will have no salvage value. Working capital is assumed to be fully recovered at the end of ten years. Depreciation is straight-line (no salvage) and National’s tax rate is 45%. The required rate of return for projects of similar risk is 8%.
Requirements
a. Should National Foods produce this new candy? What is the basis of your recommendation?
b. Would your recommendation change if production costs average 65% of net revenues instead of 60%? How sensitive is your recom- mendation to production costs?
c. Would your recommendation change if the equipment were depreciated according to MACRS as a 10-year asset instead of using straight-line?
d. Suppose that competitors are expected to introduce similar candy products to compete with Nasty, such that dollar sales will drop by 5% each year following the first-year. Should National Foods pro- duce this new candy considering this possible drop in sales? Explain.
For the NASTY-AS-CAN-BE CANDY case answer B). how was PV of Operating Cash Flows determined?