Question

You are the Chief Financial Officer of Tamuda Berhad, a leading Malaysian property developer. Tamuda Berhad is considering the development of a wireless home networking appliance, called HomeNet that will provide both the hardware and the software necessary to run an entire home from any internet connection. In addition to connecting PCs and printers, HomeNet will control new internet-capable stereos, digital video recorders, heating and air-conditioning units, major appliances, telephone and security systems, office equipment, and so on. The major competitor for HomeNet is a product being developed by Damuda Berhad. Based on extensive marketing surveys, the sales forecast for HomeNet is 50,000 units per year. Given the pace of technological change, Tamuda Berhad expects the product will have a fouryear life and an expected wholesale price of RM260. Actual production will be outsourced at a cost (including packaging) of RM110 per unit. To verify the compatibility of new consumer internet-ready appliances, as they become available, with the HomeNet system, Tamuda Berhad must also establish a new lab for testing purposes. It will rent the lab space, but will need to purchase RM10.5 million of new equipment. The salvage value of this equipment after year 4 is RM1.8 million. The equipment will be depreciated using the straight-line method over a five-year life. Tamuda Berhad’s marginal tax rate is 40% and its weighted average cost of capital is 12%. The lab will be operational at the end of one year. At that time, HomeNet will be ready to ship. Tamuda Berhad expects to spend RM2.8 million per year on rental costs for the lab space, as well as marketing and support for this project. At setup, Tamuda Berhad requires RM500,000 in net working capital which will be recaptured at the end of the project.

(a) Generate the relevant cash flows needed to analyze the proposal.

Answer 1

The relevant cash flows required to analyze this proposal are as follows:-

1) Revenue from sales of HomeNet. Assumption being that revnue is realized on shippin of product. So, HomeNet sales are realized at the end of Year 2 and not year 1

2)Packaging costs for each manufatured unit

3) The equipment installation fixed cost

4) Lab Rental expenses, marketing and support

5) Net working capital which is recovered at the end of the project , which turns out to be four years, i.e the lifetime of the product, after which it becomes obsolete.

Note that depreciation is a non cash expense

The cash flows are shown in this table

All values in RM millions

The Hotnet revenue is RM 260*50000units/yr = 13 mn RM

Packaging cost =110 RM *5000 units/yr = 5.5 mn RM

	Year 0	Year 1	Year 2	Year 3	Year 4
Revenue from HomeNet	0	0	13	13	13
Packaging cost	0	0	(5.5)	(5.5)	(5.5)
Purchase of equipment	(10.5)	0	0	0	0
Lab Rental, marketing		(2.8)	(2.8)	(2.8)	(2.8)
Net working capital(NWC)	(0.5)				0.5
Salvage from equipment	0	0	0	0	1.8

This is the cash flow schedule, we can sum up the total and find the net cash flows.

The NPV can be found by applying the discount rate of WACC. of 12%

This is the pre-tax cash schedule

The after tax cash flows will be different,

The depreciation every year calculated from straight line depreciation is 10.5/5 = 2.1 mn

Secondly, the after tax salvage value is also different,

After tax salvage value = Cash proceeds - (Cash proceeds- Book value)*Tax Rate

Cash proceeds= 1.8 mn RM

Book value at the end of fourth year = 10.5-2.1-2.1-2.1-2.1 = 2.1mn

So, they sell the equipment at a loss

After tax salvage value = 1.8- (1.-2.1)*0.4 = 1.68 mn RM

The after tax cash flows are as follows

Year 0	Year 1	Year 2	Year 3	Year 4
Revenue from HomeNet	0	0	13	13	13
Packaging cost	0	0	(5.5)	(5.5)	(5.5)
Purchase of equipment	(10.5)	0	0	0	0
Lab Rental, marketing		(2.8)	(2.8)	(2.8)	(2.8)
Net working capital(NWC)	(0.5)				0.5
Before tax net cash flows	(11.0)	(2.8)	4.7	4.7	5.2
Depreciation		(2.1)	(2.1)	(2.1)	(2.1)
Income before taxes		(4.9)	2.6	2.6	3.1
Taxes @ 40%		(1.96)	1.04	1.04	1.24
After tax net income		(2.94)	1.56	1.56	1.86
Depreciation		2.1	2.1	2.1	2.1
After tax cash flows		(0.84)	3.66	3.66	3.96
After tax salvage value					1.68
After tax total net cash flows	(11.0)	(0.84)	3.66	3.66	5.64

Now apply discount rate of 12% to find out the present values and ascertain the NPV analysis.