Question

In: Accounting

Leisure Manufacturing, Inc. is a producer of grills. Its current line of grills are selling excellently....

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 =$     

Depreciation Estimation: Use the formula stated below to calculate the depreciation expenses.

Depreciation of Year t   = Cost of equipment × MACRS percentage for Year t

[For all MACRS percentages in this part, enter as a decimal number with 4 decimal places.]     

Depreciation of Year 1 = $      ×     =$    

Depreciation of Year 2 = $      ×     =$       

Depreciation of Year 3 = $      ×     =$     

Depreciation of Year 4 = $      ×     =$  

Depreciation of Year 5 = $     ×    =$  

Net Working Capital Estimation: Use the formula stated below to calculate the net working capital requirements.

NWC for Year t   = NWC Required Percentage × Net sales of Year t

[For the NWC required percentage in this part, enter as a decimal number with 2 decimal places.]       

NWC for Year 1   =     × $      =$  

NWC for Year 2   =     × $      =$  

NWC for Year 3   =     × $      =$  

NWC for Year 4   =     × $      =$  

NWC for Year 5   = $  

CASH FLOW ESTIMATION: Complete the following table below.

Year 1

Year 2 Year 3 Year 4 Year 5
Sales $   $   $   $   $  
VC $   $   $   $   $  
Fixed costs $   $   $   $   $  
Dep $   $   $   $   $  
EBT $   $   $   $   $  
Taxes (35%) $   $   $   $   $  
NI $   $   $   $   $  
+ Dep $   $   $   $   $  
OCF $   $   $   $   $  
NWC
Beg $   $   $   $   $  
–End $   $   $   $   $  
NWC CF $   $   $   $   $  
NCF $   $   $   $   $  

Estimation of total Year 5 cash flow: Provide your responses to the following.

At the end of the project's 5-year life,

Accumulated depreciation of equipment = $  

Book value of equipment = $  

Market value of equipment = $  

Tax associated with sale of equipment = $    [Enter as a positive number if tax liability or as a negative number if tax credit.]

  

CF on sale of equipment = $  

  

Total Year 5 cash flow = $     

Hint : Net CF (Net cash flow) = OCF (Operating cash flow) + NWC CF (Net working capital cash flow)

Year 1 through Year 4 cash flow = Net CF of the individual years.

Year 5 cash flow = Net CF of Year 5 + CF on sales of equipment.  

Evaluation of Project: Fill out the following tables.

Year Cash flow
0 $  
1 $  
2 $  
3 $  
4 $  
5 $  

(Do not round your calculations. Round your answers below to the number of decimal places specified.)

Evaluation Method
Payback years (2 decimal places)
PI (Profitability Index) (2 decimal places)
IRR (Internal Rate of Return) % (2 decimal places)
NPV (Net Present Value) $   (whole number with no decimal place)

Solutions

Expert Solution

1.

Sunk cost is the cost already incurred and cannot be changed by the decision

Sunk costs are:

$6200000 being New Model Development Cost and

$1,000,000 being Marketability Studying cost

Total Sunk costs = $7,200,000

2.

Year A. unit sales of new model B. price of new model C. reduction in unit sales of existing D. Current price of existing model

E. Unit sales

of existing model if new model project is not launched

F. Reduction in

unit sales of

existing model

if new model project is launched

G.Current price of existing model H. Reduced price of existing model

I. Net sales

(AxB)-(CxD)-[(ExF)x(GxH)]

1 3500000 150 1080000 115 1800000 1080000 115 85 379200000
2 4300000 150 1190000 115 1400000 1190000 115 85 501850000
3 3200000 150 480000000
4 1800000 150 270000000
5 1200000 150 180000000

3.

Year A. unit sales of new model B. Variable cost per unit of new model C. reduction in unit sales of existing D. Current price of existing model E. Variable cost (AxB)-(CxD)
1 3500000 60 1080000 50 156000000
2 4300000 60 1190000 50 198500000
3 3200000 60 192000000
4 1800000 60 108000000
5 1200000 60 72000000

3.

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

4.

Computation of cash flow of the project:

No Year 0 1 2 3 4 5 6 7 8
A. Net Sales 379,200,000 501,850,000 480,000,000 270,000,000 180,000,000
B. Variable costs 156,000,000 198,500,000 192,000,000 108,000,000 72,000,000
C. Fixed Costs 17,500,000 17,500,000 10,000,000 10,000,000 10,000,000
D. Depreciation (POINT 3) 5,001,500 8,571,500 6,121,500 4,371,500 3,125,500 3,122,000 3,125,500 1,561,000
E. EBIT (A-B-C-D) 200,698,500 277,278,500 271,878,500 147,628,500 94,874,500 -3,122,000 -3,125,500 -1,561,000
F. 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)
G. Profit after tax (E-F) 130,454,025 180,231,025 176,721,025 95,958,525 61,668,425 (2,029,300) (2,031,575) (1,014,650)
H. 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
I. Operating cash flow (G+H) 135,455,525 188,802,525 182,842,525 100,330,025 64,793,925 1,092,700 1,093,925 546,350
J. Investment in equipment -35,000,000
K. Sale of equipment after tax 2,470,000
L. Net working capital 75,840,000 100,370,000 96,000,000 54,000,000 0
M. Change in net working capital -75,840,000 -24,530,000 4,370,000 42,000,000 54,000,000
N. Net cash flow -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
O. PVF @ 20% 1 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349 0.2791 0.2326
P. Discounted cash flow (N*O) -35,000,000 49,677,617 114,070,841 108,339,888 68,645,771 48,735,971 365,945 305,314 127,081

6.

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

IRR:

Based on the positive NPV, PI of more than 1, less payback period and an IRR more than cost, we can say that the project can be accepted.


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