Question

Leisure Manufacturing, Inc. is a producer of grills. Its current line of grills are selling excellently. However, in order to cope with the foreseeable competition from other similar products, LM spent $6,200,000 to develop a new line of expert grills (new model development cost). The grill measurses 55"W x 25"D x 48"H and weighs 60 pounds on two wheels and two stable legs. It has 4 stainless steel tube burners providing a total of 48,000 BTU on a push and turn integrated ignition system using liquid propane gas. It is versifuel compatible. That means it can be converted to use nautral gas with the implementation of the optional versifuel kit. The primary cooking area is 480 sq. inches enabling a cooking capacity of 28 burgers at the same time whereas the warming rack area is 180 sq. inches. In addition to the black stainless steel control panel and two black powder-coated side shelves on the left, the grill has a black stainless steel 12,000-BTU side burner for the preparation of sauces and side dishes on the right.  The grill includes a porcelain-coated cast iron cooking grid panel and a black porcelain-coated flame tamer for each individual burner. The warming rack is built with porcelain-coated steel. The lid is made of stainless steel with aluminized steel liner and black steel endcaps. The oval temperature gauge is located in the center of the lid. The same porcelain-coated steel is used to build the bottom bowl. Its porcelain heat plates are designed to reduce flare ups. The company had also spent a further $1,000,000 to study the marketability of this new line of expert grill model (marketability studying cost).

LM is able to produce the expert grills at a variable cost of $60 each. The total fixed costs for the operation are expected to be $10,000,000 per year. LM expects to sell 3,500,000 units, 4,300,000 units, 3,200,000 units, 1,800,000 units and 1,200,000 units of the new grill model per year over the next five years respectively. The new expert grills will be selling at a price of $150 each. To launch this new line of production, LM needs to invest $35,000,000 in equipment which will be depreciated on a seven-year MACRS schedule. The value of the used equipment is expected to be worth $3,800,000 as at the end of the 5 year project life.

LM is planning to stop producing the existing grill model entirely in two years. Should LM not introduce the expert grill, sales per year of the existing grill model will be 1,800,000 units and 1,400,000 units for the next two years respectively. The existing model can be produced at variable costs of $50 each and total fixed costs of $7,500,000 per year. The existing grill model are selling for $115 each. If LM produces the expert grill model, sales of existing model will be eroded by 1,080,000 units for next year and 1,190,000 units for the year after next. In addition, to promote sales of the existing model alongside with the expert grill model, LM has to reduce the price of the existing model to $85 each. Net working capital for the expert grill project will be 20 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. LM is currently in the tax bracket of 35 percent and it requires a 20 percent returns on all of its projects. The firm also requires a payback of 3 years for all projects.

You have just been hired by LM as a financial consultant to advise them on this expert grill project. You are expected to provide answers to the following questions to their management by their next meeting which is scheduled sometime next month.   

What is/are the sunk cost(s) for this expert grill 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 LM on how to handle such cost(s).

What are the cash flows of the project for each year?

What is the payback period of the project?

What is the PI (profitability index) of the project?  

What is the IRR (internal rate of return) of the project?

What is the NPV (net present value) of the project?

Should the project be accepted based on Payback, PI, IRR and NPV? Briefly explain.

Estimation of sunk costs

Provide below the amounts of the sunk costs you identified from the case description above.

1st sunk cost: $     being        cost  (Use exactly the same wording as in the case background information.)

2nd sunk cost: $     being     cost  (Use exactly the same wording as in the case background information.)

Total sunk costs = $  

Net Sales Estimation: Use the formula stated below to calculate the net sales.

Year t Net Sales

=Unit sales of new model for Year t × Price of new model

– Reduction in unit sales of existing model for Year t × Current price of existing model

– [(Unit sales of existing model for Year t if new model project is not launched – Reduction in unit sales of existing model if new model project is launched) × (Current price of existing model – Reduced price of existing model)]

Year 1 Net Sales

=  × $   –  × $  

     – (   –  ) × ($   – $   )

= $           

Year 2 Net Sales

=  × $   –  × $  

     – (   –  ) × ($   – $   )

= $  

Year 3 Net Sales = $  

Year 4 Net Sales = $  

Year 5 Net Sales = $  

Variable Cost Estimation: Use the formula stated below to calculate the variable costs.

Year t Variable costs

=   Unit sales of new model for Year t × Variable cost per unit of new model

   – Reduction in unit sales of existing model for Year t × Variable cost per unit of existing model

      

Year 1 Variable costs

=   × $   –  × $  

=$  

      

Year 2 Variable costs

=   × $   –  × $  

=$     

    

Year 3 Variable costs =$     

Year 4 Variable costs =$     

Year 5 Variable costs =$     

Answer 1

Part:1) Sunk cost: Cost that a firm has already incurred and can't be recovered is known as sunk cost. These costs are often irrelevant while considering a new investment or any new project.

1st sunk cost = $6,200,000. To develop a new line of expert grills(New model development cost)

2nd sunk cost = $1,000,000. To study the marketability of this new line of expert grill model (Marketability studying cost)

Part: 2)

Computation of Net sales:

Sl No	Year	1	2	3	4	5
i	Unit sales of new model	3,500,000	4,300,000	3,200,000	1,800,000	1,200,000
ii	Price of new model	150	150	150	150	150
iii	Reduction in unit sales of existing model	1,080,000	1,190,000
iv	Current price of existing model	115	115
v	Unit sales of existing model if new model project is not launched	1,800,000	1,400,000
vi	Reduction in unit sales of existing model if new model project is launched	1,080,000	1,190,000
vii	Current price of existing model	115	115
viii	Reduced price of existing model	85	85
ix	Net Sales ([i*ii]-[iii*iv]-{[v-vi]*[vii-viii]})	379,200,000	501,850,000	480,000,000	270,000,000	180,000,000

Computation of variable costs:

Sl No	Year	1	2	3	4	5
i	Unit sales of new model	3,500,000	4,300,000	3,200,000	1,800,000	1,200,000
ii	Variable cost per unit of new model	60	60	60	60	60
iii	Reduction in unit sales of existing model	1,080,000	1,190,000
iv	Variable cost per unit of existing model	50	50
v	Variable costs (i*ii)-(iii*iv)	156,000,000	198,500,000	192,000,000	108,000,000	72,000,000

Computation of cash flow of the project:

No	Year	0	1	2	3	4	5	6	7	8
i	Net Sales		379,200,000	501,850,000	480,000,000	270,000,000	180,000,000
ii	Variable costs		156,000,000	198,500,000	192,000,000	108,000,000	72,000,000
iii	Fixed Costs		17,500,000	17,500,000	10,000,000	10,000,000	10,000,000
iv	Depreciation (Note 1)		5,001,500	8,571,500	6,121,500	4,371,500	3,125,500	3,122,000	3,125,500	1,561,000
v	EBIT (i-ii-iii-iv)		200,698,500	277,278,500	271,878,500	147,628,500	94,874,500	-3,122,000	-3,125,500	-1,561,000
vi	Tax @ 35% (v*0.35) (Negative indicate savings)		70,244,475	97,047,475	95,157,475	51,669,975	33,206,075	(1,092,700)	(1,093,925)	(546,350)
vii	Profit after tax (v-vi)		130,454,025	180,231,025	176,721,025	95,958,525	61,668,425	(2,029,300)	(2,031,575)	(1,014,650)
viii	Add back: Depreciation		5,001,500	8,571,500	6,121,500	4,371,500	3,125,500	3,122,000	3,125,500	1,561,000
ix	Operating cash flow (vii+viii)		135,455,525	188,802,525	182,842,525	100,330,025	64,793,925	1,092,700	1,093,925	546,350
x	Investment in equipment	-35,000,000
xi	Sale of equipment after tax						2,470,000
xii	Net working capital (Note 2)		75,840,000	100,370,000	96,000,000	54,000,000	0
xiii	Change in net working capital		-75,840,000	-24,530,000	4,370,000	42,000,000	54,000,000
xiv	Net cash flow (ix+x+xi+xiii)	-35,000,000	59,615,525	164,272,525	187,212,525	142,330,025	121,263,925	1,092,700	1,093,925	546,350
xv	PVF @ 20%	1	0.8333	0.6944	0.5787	0.4823	0.4019	0.3349	0.2791	0.2326
xvi	Discounted cash flow (xiv*xv)	-35,000,000	49,677,617	114,070,841	108,339,888	68,645,771	48,735,971	365,945	305,314	127,081

Note 1:

Depreciation(Year 1) = 35million*14.29% = 5,001,500; Depreciation(Year 2) = 35million*24.49% = 8,571,500; Depreciation(Year 3) = 35million*17.49% = 6,121,500; Depreciation(Year 4) = 35million*12.49% = 4,371,500; Depreciation(Year 5) = 35million*8.93% = 3,125,500; Depreciation(Year 6) = 35million*8.92% = 3,122,000; Depreciation(Year 7) = 35million*8.93% = 3,125,500; Depreciation(Year 8) = 35million*4.46% = 1,561,000;

Note 2:

Net working capital = 20%of sales. Assumed while in last year all the working capital is recovered.

Pay back period = Year 0 cashflow/Year 1 cashflow = 35,000,000/49,677,617 = 0.7years

PI = Present value of future cashflow/Initial invetment = Sum of Discounted cashflow except year 0/Initial investment = (49,677,617+114,070,841+108,339,888+68,645,771+48,735,971+365,945+305,314+127,081)/35,000,000 = 390,268,430/35,000,000 = 11.15

NPV = Sum of Discounted cashflow = -35,000,000+49,677,617+114,070,841+108,339,888+68,645,771+ 48,735,971+365,945+305,314+127,081 = 355,268,430

Payback period is less than 3years, NPV is positive, IRR is more than cost of capital & PI is more than 1. Hence accept the project