Question

ABC company's vice president of marketing proposes a new program to significantly increase product sales by 250,000 units per year throughout the 1998-2004 period. Specifically, it is suggested that the company take the following actions: A. Spend $2.5 million over the period of 1998-2000 as promotional expenditures - for example, spend $1.0 million each in the years 1998, 1999, and $0.5 million in the year 2000. B. Make a one-time investment of $1.4 million in plants and equipment needed at the beginning of 1998 to generate these additional products. No new warehouse capability is needed. This investment is to be depreciated on a straight-line basis over the seven-year period. There will be no salvage values for these plants and equipment in 2005. It is further assumed that the product unit cost is $8.00 in 1998, and it is estimated to increase by 3 percent per year. The product unit price is $20 in 1998, and it is estimated to change as manifested in the following table: Items 1998 1999 2000 2001 2002 2003 2004 Unit Price $20.00 $20.60 $21.00 $21.15 $21.25 $21.25 $21.00 The SG&A expenditure is estimated at $1.25 million in 1998, and it will increase by 3 percent per year during the six-year period. A corporate tax of 40 percent must be paid for any marginal income. There is an interest charge during this period, and the company's weighted average cost of capital (WACC) is 8 percent. If the company's hurdle rate for this type of investment is 25 percent, and the NPV (Net Present Value) for the proposed marketing initiative is negative at that hurdle rate of 0.25, why would you not recommend the marketing initiative be approved? Explain in depth.

Answer 1

The net present value of the proposed investment is negative at hurdle rate of 25%. This means the marketing initiative is not generating the required rate of return and is not giving benefit in terms of present value of cash inflows

Promotional expenditure of $2.4 Million is spread over 3 years from 1998 to 2000. During this period due to heavy promotional expenditure there is negative cash inflow for 2 year . Also the sales volume generated due to this promotional campaign is not enough to give positive cash inflows. Overall there is cash outflow in spite of such heavy expenditure incurred on promotions. Negative cash inflows do not justify the initial heavy investments made in promotions

In years 2001 to 2004 there is positive cash inflows but when it is discounted and present value computed it does not justify the investment of plant and equipment

Hence the marketing initiative is not recommended

Working to support the justification