Question

Local Cost Smartphones Inc (LCS) is considering launching a new smartphone. with a product life cycle of 4 years. The firm expects to sell 10 million units per year over the next 4 years. The price of the smartphone is expected to be $99 per unit. which will decline by 5% per year.

The cost of production is expected to be $20 per unit. Furthermore, marketing and support costs are expected to be $2.5 million per year during the product life.

Initial capital expenditures are $100 million, 20% of which are expected to be salvaged at the end of year 4. There is an initial increase in NWC of $5 million during each of the first 2 years. In year 3. NWC will remain at the level of Year 2. Investments in NWC will be recovered at the end of year 4.

Note the following assumptions. Purchased capital assets become part of the CCA asset pool depreciated at the rate 40% per year and it is expected that in year 4 there will be a continuing pool and negative net additions. Furthermore, the firm's income tax rate is 35% and its cost of capital is 8%.

a) Determine the impact on NPV of the items listed below. Be careful: for items that have a negative impact on NPV, indicate their amounts as negative numbers.

i.) the initial capital expenditure and salvage of capital assets (ignore CCA tax

shields at this point)?

ii.) the incremental revenues of the project?

iii.) the incremental production costs of the project?

iv.) the changes in net working capital amounts?

v.) the equipment's CCA tax shields?

b) Determine the NPV of the new smartphone product?

c) Should the new smartphone product be launched? Why?

Answer 1

product life cycle of 4 years

*The firm expects to sell 10 million units per year over the next 4 years. The price of the smartphone is expected to be $99 per unit. which will decline by 5% per year.

*The cost of production is expected to be $20 per unit. Furthermore, marketing and support costs are expected to be $2.5 million per year during the product life

*Initial capital expenditures are $100 million, 20% of which are expected to be salvaged at the end of year 4.

*There is an initial increase in NWC of $5 million during each of the first 2 years. In year 3. NWC will remain at the level of Year 2.Investments in NWC will be recovered at the end of year 4

*Purchased capital assets become part of the CCA asset pool depreciated at the rate 40% per year and it is expected that in year 4 there will be a continuing pool and negative net additions. Furthermore, the firm's income tax rate is 35% and its cost of capital is 8%

A) Determine the impact on NPV of the items listed below. Be careful: for items that have a negative impact on NPV, indicate their amounts as negative numbers.

.

i.) the initial capital expenditure and salvage of capital assets (ignore CCA tax

shields at this point)?

.

initial capital expenditure = -$100 million

salvage of capital assets = $100 * 20% = $20

** Impact of salvage value on NPV = PV of salvage value at 0^th time as cash inflow

PV of salvage value = 20 * ( 1 / 1 + 8% )^{^4} = 20 * 0.73503 = 14.7006

PV of salvage value = $14.70

.

ii.) the incremental revenues of the project?

.

*The price of the smartphone is expected to be $99 per unit. which will decline by 5% per year.

year	1	2	3	4
Units sold	10 million	10 million	10 million	10 million
Selling price expected	$99	$94.05	$89.35	$84.88
Revenue	990 million	940.5 million	893.5 million	848.8 million
Tax Exp (35%)	346.5	329.175	312.725	297.08
After tax incremental revenue	643.5	611.325	580.775	551.72
PVIF,8%	0.925926	0.85734	0.793832	0.73503
PV of Incremental revenue	595.8333810	524.1133755	461.0377798	405.5307516
Total PV				1,986.5152879

.

iii.) the incremental production costs of the project?

.

Incremental cost of production = Cost of production + marketing cost

Incremental cost of production = ( 10 million * 20 ) + 2.5 million

Incremental cost of production = 200 million + 2.5 million = 202.5 million per year

Tax expenses deduction = 202.5 - 35% = 131.625 per each 4 year

PV of Incremental cost = 131.625 * PVIFA, 8%, 4 year

PVIFA, 8%, 4 year = 3.31212683

PV of Incremental cost = 131.625 * 3.31212683 = $670.705683

Impact on NPV

incremental production costs of the project = -$435.9586939

.

iv.) the changes in net working capital amounts?

.

First year = 5 million outflow

Second year = 5 million outflow

Third year = 0

Fourth year end = 10 million inflow (release of wic )

Net effect on NPV

PV of WIC = ( -5 / 1.08 )^{^0 +} ( -5 / 1.08 )^{^1} + ( 10 / 1.08)^{^4}

PV = -5 + -4.629629629 + 7.35029849 = -$2.279331

.

v.) the equipment's CCA tax shields?

.

PV(CCA Tax shields) = ( ( ( 100 * 0.4 * 0.35 ) / (0.08 + 0.4 ) ) * ( ( 1 + ( 0.08 / 2 ) ) / 1.08 ) ) - ( ( 100 * 0.2 * 0.4 * 0.35 ) / ( 0.08 + 0.4 ) ) * ( 1 / 1.08^{^4} )

PV(CCA Tax shields) = 23.798746

b) Determine the NPV of the new smartphone product?

.

NPV = -100 + 14.7006 + 1,986.5152879 + -435.9586939 + -2.279331 + 23.798746

NPV = 1486.776609

.

c) Should the new smartphone product be launched? Why?

.

Yes, because NPV is greater than Zero