Question

Financial analysis of new products at Bay City Electronics had always been rather informal. Bill Roberts, who founded the firm in 1970, knew residential electronics because he had worked for almost seven years for another firm specializing in home security systems. But, he had never been trained in financial analysis. In fact, all he knew was what the bank had asked for every time he went to discuss his line of credit.

         

Bay City had about 45 full?time employees (plus a seasonal factory work force) and did in the neighborhood of $18 million in sales. His products all related to home security and were sold by his sales manager, who worked with a group of manufacturers' reps, who in turn called on wholesalers, hardware and department store chains, and other large retailer. He did some consumer advertising, but not much.

         

Bill was inventive, however, and had built the business primarily by coming up with new techniques. His latest device was a remote­-controlled electronic closure for any door in the home. The closure was effected by a special ringing of the telephone: for example, if a user wanted to leave a back door open until 9:00 p.m. it was simple to call the house at 9:00 and wait for 10 rings, after which the electronic device would switch the door to a locked position. A similar call would reopen the door.

         

The bank liked the idea but wanted Bill to do a better job of financial analysis. Based on his understanding of this market, Bill filled out the FINANCIAL worksheet as appears at the end of the exercise. To date, Bay City had spent $85,000 in expense money for supplies and labor developing the closure and had invested $15,000 in a machine (asset). If the company decided to go ahead, it would have to invest $50,000 more in a new facility, continue R&D to validate and improve the product, and--if things went according to expectations--invest another $45,000 in year 3 to expand production capability.

         

1) Use the given data to calculate the NPV for the electronic closure product. Do the numbers look good?

2) How is NPV affected if the following contingencies occur? (Assess each of these separately.)

a) Direct manufacturing cost estimate may be overly optimistic, and may never get below the original $16.

b) Competition may force higher marketing costs – what if starting in year 2 the level that must be spent is exactly twice what was forecasted above?

Year	0	1	2	3	4	5
Unit sales	0	4000	10000	18000	24000	5000
Revenue per unit	0	52	52	52	52	52
Dollar sales	0	208000	520000	936000	1248000	260000
Production costs:
Direct	0	64000	120000	198000	216000	70000
Indirect	0	12800	24000	39600	43200	14000
Total	0	76800	144000	237600	259200	84000
Gross profit	0	131200	376000	698400	988800	176000
Direct marketing costs	0	100000	80000	50000	60000	10000
Profit contribution	0	31200	296000	648400	928800	166000
Overheads (excluding R&D):
Division	0	0	0	0	0	0
Corporate	0	20800	52000	93600	124800	26000
Total	0	20800	52000	93600	124800	26000
Other expenses:
Depreciation	16250	16250	16250	31250	15000	15000
Cannibalization	0	20800	52000	93600	124800	26000
R&D to be incurred		15000	10000	15000	10000
Extraordinary expense	0	0	5000	0	0	0
Project abandonment	3000	0	0	0	0	0
Total	19250	52050	83250	139850	149800	41000
Overheads and expenses	19250	72850	135250	233450	274600	67000
Income before taxes	-19250	-41650	160750	414950	654200	99000
Tax effect:
Taxes on income	-6545	-14161	54655	141083	222428	33660
Tax credits	-65	-142	547	1411	2224	337
Total effect	-6480	-14019	54108	139672	220204	33323
Cash flow:
Income after taxes	-12770	-27631	106642	275278	433996	65677
Depreciation	16250	16250	16250	31250	15000	15000
Production facilities	50000			45000
Working capital: Cash	0	20800	31200	41600	31200	-124800
Working capital: Inventories	0	20800	31200	41600	31200	-99840
Working capital: Acc. Rec.	0	31200	46800	62400	46800	-187200
Net cash flows	-46520	-84181	13692	115928	339796	492517
Discounted flows	-46520	-67888	8904	60803	143725	168001

Assumptions:

Tax Rate:	34%
Tax Credits (as % of tax rate):	1%
Cost of Capital:	24%
Working Capital:
Cash as % of Sales	10%
Invent. as % of Sales	10%
Accounts Receivable as % of Sales	15%
WC Recovery in Year 5
% of Cash	100%
% of Inventory	80%
% of Accounts Rec.	100%

Answer 1

1...Year	0	1	2	3	4	5
Unit sales	0	4000	10000	18000	24000	5000
Revenue per unit	0	52	52	52	52	52
Dollar sales	0	208000	520000	936000	1248000	260000
Production costs:
Direct	0	64000	120000	198000	216000	70000
Indirect	0	12800	24000	39600	43200	14000
Total	0	76800	144000	237600	259200	84000
Gross profit	0	131200	376000	698400	988800	176000
Direct marketing costs	0	100000	80000	50000	60000	10000
Profit contribution	0	31200	296000	648400	928800	166000
Overheads (excluding R&D):
Division	0	0	0	0	0	0
Corporate	0	20800	52000	93600	124800	26000
Total	0	20800	52000	93600	124800	26000
Other expenses:
Depreciation	16250	16250	16250	31250	15000	15000
Cannibalization	0	20800	52000	93600	124800	26000
R&D to be incurred		15000	10000	15000	10000
Extraordinary expense	0	0	5000	0	0	0
Project abandonment	3000	0	0	0	0	0
Total	19250	52050	83250	139850	149800	41000
Overheads and expenses	19250	72850	135250	233450	274600	67000
Income before taxes	-19250	-41650	160750	414950	654200	99000
Tax effect:
Taxes on income	-6545	-14161	54655	141083	222428	33660
Tax credits	-65	-142	547	1411	2224	337
Total effect	-6480	-14019	54108	139672	220204	33323
Cash flow:
Income after taxes	-12770	-27631	106642	275278	433996	65677
Depreciation	16250	16250	16250	31250	15000	15000
Production facilities	50000			45000
Working capital: Cash	0	20800	31200	41600	31200	-124800
Working capital: Inventories	0	20800	31200	41600	31200	-99840
Working capital: Acc. Rec.	0	31200	46800	62400	46800	-187200
Net cash flows	-46520	-84181	13692	115928	339796	492517
Discounted flows	-46520	-67888	8904	60803	143725	168001
Net Present Value	267025
The project can be recommended as it turns out a positive NPV.

2. a) Direct mfg. cost at $ 16	0	1	2	3	4	5
Unit sales	0	4000	10000	18000	24000	5000
Revenue per unit	0	52	52	52	52	52
Dollar sales	0	208000	520000	936000	1248000	260000
Production costs:
Direct manufacturing costs at $ 16/unit	0	64000	160000	288000	384000	80000
Indirect	0	12800	24000	39600	43200	14000
Total	0	76800	184000	327600	427200	94000
Gross profit	0	131200	336000	608400	820800	166000
Direct marketing costs	0	100000	80000	50000	60000	10000
Profit contribution	0	31200	256000	558400	760800	156000
Overheads (excluding R&D):
Division	0	0	0	0	0	0
Corporate	0	20800	52000	93600	124800	26000
Total	0	20800	52000	93600	124800	26000
Other expenses:
Depreciation	16250	16250	16250	31250	15000	15000
Cannibalization	0	20800	52000	93600	124800	26000
R&D to be incurred		15000	10000	15000	10000
Extraordinary expense	0	0	5000	0	0	0
Project abandonment	3000	0	0	0	0	0
Total	19250	52050	83250	139850	149800	41000
Overheads and expenses	19250	72850	135250	233450	274600	67000
Income before taxes	-19250	-41650	120750	324950	486200	89000
Tax effect:
Taxes on income	-6545	-14161	41055	110483	165308	30260
Tax credits	-65	-142	411	1105	1653	303
Total effect	-6480	-14019	40644	109378	163655	29957
Cash flow:
Income after taxes	-12770	-27631	80106	215572	322545	59043
Depreciation	16250	16250	16250	31250	15000	15000
Production facilities	50000			45000
Working capital: Cash	0	20800	31200	41600	31200	-124800
Working capital: Inventories	0	20800	31200	41600	31200	-99840
Working capital: Acc. Rec.	0	31200	46800	62400	46800	-187200
Net cash flows	-46520	-84181	-12844	56222	228345	485883
PV F at 24% COC	1	0.80645	0.65036	0.52449	0.42297	0.34111
Discounted flows	-46520	-67888	-8354	29488	96584	165738
Net Present Value	169048
In the event of case 2.a. NPV decreases by 267025-169048=
97977
Almost $ 100000 than in 1.

2..b) Starting yr. 2 ,mkg. Costs spent is twice than forecast	0	1	2	3	4	5
Unit sales	0	4000	10000	18000	24000	5000
Revenue per unit	0	52	52	52	52	52
Dollar sales	0	208000	520000	936000	1248000	260000
Production costs:
Direct manufacturing costs	0	64000	120000	198000	216000	70000
Indirect	0	12800	24000	39600	43200	14000
Total	0	76800	144000	237600	259200	84000
Gross profit	0	131200	376000	698400	988800	176000
Direct marketing costs	0	100000	160000	100000	120000	20000
Profit contribution	0	31200	216000	598400	868800	156000
Overheads (excluding R&D):
Division	0	0	0	0	0	0
Corporate	0	20800	52000	93600	124800	26000
Total	0	20800	52000	93600	124800	26000
Other expenses:
Depreciation	16250	16250	16250	31250	15000	15000
Cannibalization	0	20800	52000	93600	124800	26000
R&D to be incurred		15000	10000	15000	10000
Extraordinary expense	0	0	5000	0	0	0
Project abandonment	3000	0	0	0	0	0
Total	19250	52050	83250	139850	149800	41000
Overheads and expenses	19250	72850	135250	233450	274600	67000
Income before taxes	-19250	-41650	80750	364950	594200	89000
Tax effect:
Taxes on income	-6545	-14161	27455	124083	202028	30260
Tax credits	-65	-142	275	1241	2020	303
Total effect	-6480	-14019	27180	122842	200008	29957
Cash flow:
Income after taxes	-12770	-27631	53570	242108	394192	59043
Depreciation	16250	16250	16250	31250	15000	15000
Production facilities	50000			45000
Working capital: Cash	0	20800	31200	41600	31200	-124800
Working capital: Inventories	0	20800	31200	41600	31200	-99840
Working capital: Acc. Rec.	0	31200	46800	62400	46800	-187200
Net cash flows	-46520	-84181	-39380	82758	299992	485883
PV F at 24% COC	1	0.80645	0.65036	0.52449	0.42297	0.34111
Discounted flows	-46520	-67888	-25612	43405	126889	165738
Net Present Value	196013
In the event of case 2.b. NPV decreases by 267025-196013=
71012
Lesser decrease than in 2.a. By almost $ 29000