Question

HappyPups makes pet cameras and will be introducing their newest product, the Furbo. The Furbo is a camera that allows dog owners to check in on their pup, give their pup a treat, and talk to them while they are away. HappyPups spent $375,000 on consumer demand studies and an additional $40,000 on research and development to get the perfect product for all pet lovers. Each Furbo will sell for $195. It is expected that Furbo product will generate additional revenue from the sale of treats that are compatible with device. It is expected that 50% of Furbo purchases will result in an additional $15 net profit from treat sales at time of purchase. The Furbo has a variable cost of $125.00, and the project will incur an annual fixed cost of $1,400,000 each year. HappyPups will need to purchase a new machine to manufacture the Furbo for $2,000,000, and will be depreciated using the 3-yr MACRS schedule. HappyPups anticipates it will be able to sell the machine for $750,000 at the end of the project in three years. In order to promote the product, HappyPups will initially set aside $1,000,000 worth of inventory at the beginning of the project and will readjust NWC levels to reflect 10% of Furbo Sales (not including the treats). All inventory will be liquidated at the end of project. However, by introducing the Furbo, HappyPups anticipate that will take away roughly $1,000,000 in revenue each year from its existing pet camera line. The required return for the project is 20%, and the tax rate is 21%

• Spent $375,000 and $40,000 on consumer demand studies and R&D
• Sales: 80,000 units, 70,000 units, 60,000 units.
• Retail price: $195, Variable Costs $125, and $1,400,000 in fixed costs
• 50% of Furbo purchases will result an additional $15 in revenue from Treat sales
• Machine to manufacture the product: $2,000,000, depreciated using 3yr MACRS schedule. Will be able to sell for $750,000 at the end of the 3^rd year.
• $1,000,000 will be set aside in inventory, and then adjust to 10% of Furbo sales (just the camera), and will be liquidated and recouped at the end of the project
• $1,000,000 in revenue will be lost each year from HappyPup’s existing pet camera line.

Year	MACRS
1	33.33%
2	44.45%
3	14.81%
4	7.41%

1. Calculate the Operating Cash flows for the project.
2. Calculate the Cash Flow From Assets for this Project.
3. What is the net present value of this project? Should the project be accepted or rejected?
4. What is the IRR of this project (round to nearest number)?
5. HappyPups does not have enough cash for the machine. HappyPups current has a debt-to-equity ratio of .7, and does not want to alter its capital structure. If HappyPups will be charged 8% to raise debt and 10% to raise equity, how much will the machine effectively cost HappyPups?
6. Using the information in number 5, what is the new net present value of the project?

Answer 1

3-year MACRS schedule:

Operating cash flow calculation:

NPV calculation:

1). Operating cash flows: Year 1 = 3,141,986

Year 2 = 2,576,440

Year 3 = 1,839,702

2). Free cash flows: Year 1 = 2,581,986

Year 2 = 2,771,440

Year 3 = 2,838,324

3). NPV = 3,291,731

The project should be accepted as it has a positive NPV.

4). IRR of the project = 78%

5). New required return = (debt ratio*cost of debt*(1-Tax rate)) + (equity ratio*cost of equity)

D/E = 0.7 so E/(D+E) or E/V = 1/(1+0.7) = 0.588

D/V = 1-E/V = 1-0.588 = 0.4128

New required return = (0.412*8%*(1-21%)) + (0.588*10%) = 8.485%

Machine cost is 2,000,000 but cash will be raised at a cost of 8.485% so cost of funds = 8.485%*2,000,000 = 169,694.12

Effective cost of the machine = 2,000,000 + 169,694.12 = 2,169,694.12

6). Discounting the free cash flows at the discount rate of 20%,

NPV = -(2,169,694.12 + 1,000,000) + 2,581,986/(1+20%) + 2,771,440/(1+20%)^2 + 2,838,324/(1+20%)^3 = 3,122,037