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Sunshine Travel, Inc. is a producer of upright suitcases. Its current line of upright suitcases are...
Sunshine Travel, Inc. is a producer of upright suitcases. Its current line of upright suitcases are selling excellently. However, in order to cope with the foreseeable competition from other similar products, ST spent $5,900,000 to develop a new line of smart upright suitcases (new model development cost) that enable users to track easily the location of their suitcases using an app on their cell phones. The smart suitcase model has a built-in global tracker which applies the state-of-the-art micro-electronics and ground-based cellular telephone technologies to track and report its location. In addition, its digital self scale weighs itself automatically once it is filled with contents. The sensors in the side studs of the suitcase will send the information on the measured weight to the accompanying app on the user's cell phone for his/her review so as to avoid unnecessary overweight charges by the airlines when flying. The suitcase's shell is made of polycarbonate that will certainly provide extra strength and durability to protect the contents inside it. Its fine wheels and lightweight handle make the suitcase super easy to use by travelers. The suitcase's TSA friendly locks provide convenience and its multidirectional 360 degree dual wheels enable its user to move the suitcase more smoothly and in a more stable way at the same time. The company had also spent a further $1,000,000 to study the marketability of this new line of smart upright suitcases (marketability studying cost). ST is able to produce the smart upright suitcases at a variable cost of $110 each. The total fixed costs for the operation are expected to be $10,000,000 per year. ST expects to sell 3,200,000 suitcases, 3,700,000 suitcases, 2,600,000 suitcases, 1,500,000 suitcases and 1,000,000 suitcases of the new model per year over the next five years respectively. The new smart upright suitcases will be selling at a price of $150 each. To launch this new line of production, ST 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. ST is planning to stop producing the existing suitcase model entirely in two years. Should ST not introduce the smart upright suitcases, sales per year of the existing model will be 1,500,000 suitcases and 1,100,000 suitcases for the next two years respectively. The existing model can be produced at variable costs of $90 each and total fixed costs of $7,500,000 per year. The existing suitcases are selling for $120 each. If ST produces the smart upright model, sales of existing model will be eroded by 900,000 suitcases for next year and 935,000 suitcases for the year after next. In addition, to promote sales of the existing model alongside with the smart upright model, ST has to reduce the price of the existing model to $70 each. Net working capital for the smart upright suitcase 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. ST is currently in the tax bracket of 35 percent and it requires a 15 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 ST as a financial consultant to advise them on this smart upright suitcase 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 smart upright suitcase 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 ST 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
Solutions
Expert Solution
| Sunshine Travels Inc | |||
| a | Sunk Cost | ||
| The new Model Development cost of $5.9M and Market | |||
| Feasibility study cost of $1 M are sunk cost. | |||
| Theose costs are already incurred and even of the new | |||
| suitacse model production does not happen , it will not | |||
| be recovered. | |||
| There fore these two costs are sunk cost. | |||
| Total amount of sunk cost is $6.9M | |||
| The Sunk costs should not be considered for cash flow projection | |||
| as those does not influence the Project selection decision. | |||
| Production of Old model | |||
| Year 1 | Year 2 | ||
| Sales vol without new model | 1,500,000 | 1,100,000 | |
| Contribution per Unit | $ 30.0 | $ 30.0 | |
| Sales revenue w/o new model | $ 45,000,000 | $ 33,000,000 | |
| Sales Vol when new model introduced | 900,000 | 935,000 | |
| Contribution/unit when new model introduced | $ (20.00) | $ (20.00) | |
| Sales revenue when new model introduced | $ (18,000,000) | $ (18,700,000) | |
| Opportunity Loss when New Model introduced | $ (63,000,000) | $ (51,700,000) | |
| Equipment Price | $ 35,000,000.00 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| MACRS depreciation | 14.29% | 24.29% | 17.49% | 12.49% | 8.93% |
| Cumulative Depreciation after 5 years | 77.49% |
| Book Value after 5 years= 22.51% | $ 7,878,500.00 |
| Salvage value | $ 3,800,000.00 |
| Capital Loss for Tax purpose | $ (4,078,500.00) |
| Sales Vol | 3,200,000 | 3,700,000 | 2,600,000 | 1,500,000 | 1,000,000 | ||
| Rate /unit | $ 150 | $ 150 | $ 150 | $ 150 | $ 150 | ||
| Sales Revenue /Year | $ 480,000,000 | $ 555,000,000 | $ 390,000,000 | $ 225,000,000 | $ 150,000,000 | ||
| Less Variable cost @$110/unit | $ 352,000,000 | $ 407,000,000 | $ 286,000,000 | $ 165,000,000 | $ 110,000,000 | ||
| Less Fixed cost per year | $ 10,000,000 | $ 10,000,000 | $ 10,000,000 | $ 10,000,000 | $ 10,000,000 | ||
| Depreciation per year @MACRS rates | $ 5,001,500.00 | $ 8,501,500.00 | $ 6,121,500.00 | $ 4,371,500.00 | $ 3,125,500.00 | ||
| Taxable Income per year=1-2-3-4 | $ 112,998,500.0 | $ 129,498,500.0 | $ 87,878,500.0 | $ 45,628,500.0 | $ 26,874,500.0 | ||
| Tax @35% | $ 39,549,475.00 | $ 45,324,475.00 | $ 30,757,475.00 | $ 15,969,975.00 | $ 9,406,075.00 | ||
| Post Tax Operating Income | $ 73,449,025.00 | $ 84,174,025.00 | $ 57,121,025.00 | $ 29,658,525.00 | $ 17,468,425.00 |
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | ||
| Investment in Equipment | $ (35,000,000) | ||||||
| NWC Required @ 20% of Sales | $ (96,000,000) | $ (111,000,000) | $ (78,000,000) | $ (45,000,000) | $ (30,000,000) | ||
| Salvage from Equipment | $ 3,800,000.00 | ||||||
| Opportunity Cost of Revenue loss from Old model | $ (63,000,000) | $ (51,700,000) | |||||
| Post Tax Operating Income from 7 | $ 73,449,025.00 | $ 84,174,025.00 | $ 57,121,025.00 | $ 29,658,525.00 | $ 17,468,425.00 | ||
| Add Tax Gain from Capital Loss of Equipment | $ 1,427,475 | ||||||
| Add back Depreciation | $ 5,001,500.00 | $ 8,501,500.00 | $ 6,121,500.00 | $ 4,371,500.00 | $ 3,125,500.00 | ||
| Total Cash Flow | $ (35,000,000) | $ (80,549,475) | $ (70,024,475) | $ (14,757,475) | $ (10,969,975) | $ (4,178,600) | |
| Discount Factor @15% | 1 | 0.869565217 |
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