Question

Brookite Company (BC) wants to purchase a new machine costing $500,000 which will last 12 years to make Hoverboard – a new product. Because BC deals in products that are consumer oriented where tastes change rapidly, they assume a useful life for their products of 5 years. This machine could be sold for $200,000 at the end of Year 5 or for $50,000 at the end of 12 years.

• Brookite will have to increase its inventory and accounts receivable by $150,000 at the beginning of year 1 and by an additional $50,000 at the beginning of Year 2. They can recover only $150,000 of this working capital investment at the end of Year 5.
• Assume all of the following cash inflows occur at the end of the year.
• The new product revenues are expected to be as follows:

       Year 1          $400,000

       Year 2          $500,000

       Year 3          $700,000

       Year 4          $700,000

       Year 5          $300,000

• Cash outflows for the production of the Hoverboard will be 50% of revenues in Years 1, 2, and 3 and 60% of revenues in Years 4 and 5.
• BC will spend $100,000 on an advertising campaign in Year 1
• An additional $20,000 will be spent on advertising each year for years 2-5 (treat as an annuity)
• As part of the decision whether to make the Hoverboard, BC spent $100,000 on a preliminary market study last year.
• The machine will be in a CCA class where the rate is 20% . Taxes are 40% and Brookite requires 10% rate of return.

Should Brookite Company purchase this new machine? Include a calculation of the net present value, margin of safety and discounted payback . Also include qualitative points that should be considered.

Answer 1