Question

New Product Analysis

You have recently graduated with a BBA degree, and you have taken a job with a local manufacturing company. Your boss has asked you to analyze a potential new product, and to recommend if the company should produce and sell the product. Specifically, your boss wants you to prepare a spreadsheet that shows the free cash flows the product would generate, and shows what the product's net present value and internal rate of return are and what your recommendation is (see Table 12.1 in the textbook).

Marketing information: Your company already has spent $80,000 to conduct market research about the demand for the product, which indicates the optimal wholesale price for the product would be $12.00 per unit, based on the prices of similar products that competitors sell. The market research also indicates that demand for the product would last for five years. At a price of $12.00 per unit, the market research suggests that sales would be 200,000 units in the first year, and unit sales would increase 10% per year over the remaining four years of the product's life.

Production information: Your company's production manager estimates manufacturing the product would require a machine that costs $900,000, and falls in the 3-year MACRS depreciation class. The machine's expected salvage value in five years is expected to be $150,000. The production manager also estimates the product's variable costs, consisting of raw materials and labor, would be $9.50 per unit, and the annual fixed costs excluding depreciation would be $200,000. He states the product could be manufactured in a building for which your company has no other use.

Financial information: Your company's stock price is $41.10 per share, the last annual dividend was $1.75 per share, and market analysts who follow your company's stock expect the dividends to grow forever at a rate of 4.5% per year. The company's beta is 1.35 and Treasury bills are paying 2.0% per year. The company's bonds have a par value of $1,000, pay a coupon of 5.0% per year, semiannually, have 15 years to maturity, and are trading at $925.

The company's treasurer estimates that the new product would require a $300,000 increase in net working capital. She also has told you the company's target capital structure is 40% debt and 60% equity, the company's tax rate is 25%, and she expects the stock market return over the next year will be 7.0%.

Answer 1

Let us first calculate the weighted average cost of capital using the financial information provided.

Cost of equity: This can be calculated either by DDM or CAPM. In the given caselet, we do not have sufficient information for CAPM and hence, we shall use DDM. As per DDM model,

K_e = (D₁ / P₀) + g

Where,

K_e is cost of equity

D₁ is the dividend next year

P₀ is the current price

g is the growth rate in dividends

In the given problem,

K_e = [(1.75 * 1.045) / 41.1] + 0.045 = 8.95%

Cost of debt: This can be calculated by finding the YTM (Yield to maturity) on the issued bonds. For this, I have used the IRR function in Excel.

Pre tax cost of debt comes to be = 2.877%

Tax rate = 25%

Post tax cost of debt = 2.877% * (1-0.25) = 2.157%

Weighted average cost of capital or discount rate

= (K_e * w_e) + (K_d * w_d) = (0.6 * 8.95%) + (0.4 * 0.02157) = 6.23%

Where,

K_e is the cost of equity

W_e and w_d are the weights of equity and debt respectively

K_d is the post tax cost of debt

Finding out the NPV and IRR

Recommendation

Accept the project since NPV>0.