Question

ZCM manufactures camera drones. The company currently has one existing model (ZC1G) on the market. Given the growing interest in aerial photography, the existing model (ZC1G) has been a success and the company is currently considering introducing a new model to replace the existing model. Prior to developing the new model, the company has conducted a survey to determine the features users are looking for in camera drones and try to incorporate these features in the new model. The company spent $200,000 on the survey. The new model will be named ZC-2G. The main selling points for the new model (ZC-2G) are a longer flying time and an advance stability system for steady shot, allowing better picture quality. To achieve a longer flying time, ZCM has developed a new lighter battery which will be fitted onto the new drone (ZC-2G). ZCM has spent $750,000 to develop the new battery. The project is estimated to last for five years. The estimated sales volume is 2,000, 3,000, 3,000, 4,000 and 3,000 per each of the next five years respectively. The selling price will be set at $1,400 per unit in the first year and is expected to decrease by 10 percent every year due to the competitive nature of the industry. The variable cost will be $700 per unit in the first year and the fixed cost for the project will be $400,000 per year. Both variable cost and fixed cost are expected to remain constant over the five-year period. Furthermore, the company will need to invest $960,000 to purchase the necessary equipment. This $960,000 will be 100 percent depreciated straight line over 6 years. The equipment can be sold for $220,000 (before tax) at the end of the project. The project will require ZCM to make an investment in net working capital of $200,000 at the beginning of the project. Subsequently, the net working capital at the end of each year (year 1 to year 4) will increase by 10 percent every year. ZCM has a 35 percent corporate tax rate and a WACC of 19 percent. ZCM believes that the risk of the new project is similar to the risk of the company’s existing operations. As previously stated, ZCM currently has one model of camera drone (ZC-1G) on the market. The introduction of the new model (ZC-2G) will likely take customers away from the existing model (ZC-1G). Since the company will only cease production of the ZC-1G model in three years’ time, the company estimates that this will result in a decrease in operation cash flows of $300,000 per year in the first three years of the project’s life (year 1 to year 3). Based on the above information, should the company proceed with the project?

Answer 1

Solution:

* Below mentioned in the calculation of net revenue each year.

Years	Units	S.P	Var. Cost	Contribution	Fixed Cost	Profit
1	2000	1400	700	700 * 2000= 14,00,000	4,00,000	10,00,000
2	3000	1260	700	560 * 3000 = 16,80,000	4,00,000	12,80,000
3	3000	1134	700	434 * 3000 = 13,02,000	4,00,000	9,02,000
4	4000	1020	700	320 * 4000 = 12,80,000	4,00,000	8,80,000
5	3000	918	700	218 * 3000 = 6,54,000	4,00,000	2,54,000
						43,16,000

Yr	Particulars	Amount	Depreciation	Net Profit	Tax	PAT	W.C	WACC	Net Amount
0	Spent on Survey	(2,00,000)	-	(2,00,000)	-	(2,00,000)		1	(2,00,000)
0	Battery	(75,000)	-	(75,000)		(75,000)		1	(75,000)
0	Machinery	(9,60,000)	-	(9,60,000)		(9,60,000)		1	(9,60,000)
1	Profit from Sales	10,00,000	1,92,000	8,08,000	2,82,800	5,25,200	(2,00,000)	0.8403	2,73,265
2	Profit from Sales	12,80,000	1,92,000	10,88,000	3,80,800	7,07,200	(2,20,000)	0.7062	3,44,060
3	Profit from Sales	9,02,000	1,92,000	7,10,000	2,48,500	4,61,500	(2,42,000)	0.5934	1,30,251
4	Profit from Sales	8,80,000	1,92,000	6,88,000	2,40,800	4,47,200	(2,66,200)	0.4987	90,264
5	Profit from Sales	2,54,000	1,92,000	62,000	21,700	40,300		0.4190	16,885
5	Profit on Sale of machinery	24,000 (2,20,000-1,92,000)	-	24,000	8,400	15,600		0.4190	6536
									(3,73,736)

However, depreciation is deducted from profit for the purpose of calculation of tax. It doesnt result in actual cash outflow. So add back depreciation to arrive at actual cash flow. The following table depicts the same and help us to ascertain whether to accept the project or not.

Year	PAT	Depreciation	W.C	Net Amount	WACC	Net Present Value
1	5,25,200	1,92,000	(2,00,000)	5,17,200	0.8403	4,34,600
2	7,07,200	1,92,000	(2,20,000)	6,79,200	0.7062	4,79,651
3	4,61,500	1,92,000	(2,42,000)	4,11,500	0.5934	2,44,184
4	4,47,200	1,92,000	(2,66,200)	3,73,000	0.4987	1,86,015
5	40,300	1,92,000		2,32,300	0.4190	97,333
						14,41,783

The Resultant is as follows:

Year	Particulars	Amount
0	Cash Outflow (as per Table 2)	(12,35,000)
1-5	Net Cash Inflow (as per Table 3)	14,41,783
5	Profit On sale of Machinery (as per Table 2)	6,536
	Net Cash Inflow	2,13,319

Thus, it results in total net cash inflow  $ 2,13,319. So , should accept the project.