Hoosier Manufacturing, Inc. is a producer of household vacuum cleaning robots. Its current line of cleaning robots are selling excellently. However, in order to cope with the foreseeable competition with other similar cleaning robots, HM spent $6,000,000 to develop a new line of smart vacuum cleaning robots that can automatically adjust to all floor types and return to its dock for Lithium Ion recharging its battery for up to run time of 6 hours. The robot model also has a built-in camera for easier navigation and thus can detect and avoid stairs and other drop-offs. It automatically provides more air power on carpets and rugs. Its lower profile cleans under furniture and bed more efficiently.It has a cleaning path of 4.5” and can clean up to 2,000 sq. ft. per cleaning job. Its enhanced HEPA-style filter can trap more dirt, dust and allergens and as tiny as 0.8 micron.
It has a tangle-free extractor that can prevent any hair and debris clog. It is a bagless model with an easy to empty dust cup. Its associated smart phone/tablet application can enable consumers to set their cleaning schedules with their preferences to clean their places from anywhere. The company had also spent a further $1,200,000 to study the marketability of this new line of smart vacuum cleaning robots.
HM is able to produce the new vacuum cleaning robots at a variable cost of $570 each. The total fixed costs for the operation are expected to be $8,000,000 per year. HM expects to sell 3,200,000 robots, 2,600,000 robots, 1,600,000 robots, 1,200,000 robots and 1,000,000 robots of the new model per year over the next five years respectively. The new smart vacuum cleaning robots will be selling at a price of $640 each. To launch this new line of production, HM needs to invest $32,000,000 in equipment which will be depreciated on a seven-year MACRS schedule. The value of the used equipment is expected to be worth $4,000,000 as at the end of the 5 year project life.
HM is planning to stop producing the existing vacuum cleaning robots entirely in two years. Should HM not introduce the new smart vacuum cleaning robots, sales per year of the existing vacuum cleaning robots will be 1,600,000 robots and 1,250,000 robots for the next two years respectively. The existing vacuum cleaning robot model can be produced at variable costs of $460 each and total fixed costs of $4,500,000 per year. The existing vacuum cleaning robots are selling for $550 each. If HM produces the new smart vacuum cleaning robots, sales of existing vacuum cleaning robots will be eroded by 600,000 robots for next year and 400,000 robots for the year after next. In addition, to promote sales of the existing vacuum cleaning robots alongside with the new smart ones, HM has to reduce the price of the existing vacuum cleaning robots to $500 each. Net working capital for the new smart vacuum cleaning robot project will be 15 percent of sales and will vary with the occurrence of the cash flows. As such, there will be no initial NWC required.
The first change in NWC is expected to occur in year 1 according to the sales of the year. HM is currently in the tax bracket of 35 percent and it requires an 18 percent returns on all of its projects.
You have just been hired by HM as a financial consultant to advise them on this new smart vacuum cleaning robot project. You are expected to provide answers to the following questions to their management by their next meeting which is scheduled sometime next month.
1. What is/are the sunk cost(s) for this new smart vacuum cleaning robot project? Briefly Explain. You have to tell what sunk cost is and the amount of the total sunk cost(s). In addition, you have to advise HM on how to handle such cost(s).
2. What are the cash flows of the project for each year?
3. What is the payback period of the project? Should it be accepted if HM requires a payback of 3 years for all projects?
4. What is the PI (profitability index) of the project?
5. What is the IRR (internal rate of return) of the project?
6. What is the NPV (net present value) of the project?
7. Should the project be accepted based on PI, IRR and NPV? Briefly explain.