Question

Suppose that Linksys is considering the development of a wireless home networking appliance, called HomeNet. Based on extensive marketing surveys, the sales forecast for HomeNet is 65,000 units per year. Given the pace of technological change, Linksys expects the product will have a five-year life and an expected wholesale price of $250 (the price Linksys will receive from stores). Actual production will be outsourced at a cost (including packaging) of $135 per unit.

Linksys must also establish a new lab for testing purposes. They will rent the lab space, but will need to purchase $8.2 million of new equipment. The equipment will be depreciated using the straight-line method over a 10-years life. Linksys' marginal tax rate is 35%.

The lab will be operational at the end of one year. At that time, HomeNet will be ready to ship. Linksys expects to spend $3.1 million per year on rental costs for the lab space, as well as rent marketing and support for this product.

HomeNet project has risks similar to its existing projects, for which it has a cost of capital of 10%.  

Linksys sells the lab equipment for 3.5 million in the beginning of Year 6.

Calculate incremental cash flow and NPV.

Answer 1

Tax rate		35%
Calculation of after-tax salvage value
Cost of machine			$   8,200,000
Depreciation (8200000*5/10)			$   4,100,000
WDV	Cost less accumulated depreciation	$   4,100,000
Sale price			$   3,500,000
Profit/(Loss)	Sale price less WDV	$     (600,000)
Tax	Profit/(Loss)*tax rate	$     (210,000)
Sale price after-tax	Sale price less tax		$   3,710,000
Calculation of annual operating cash flow
		Year-1	Year-2	Year-3	Year-4	Year-5
No of units		-	65,000	65,000	65,000	65,000
Selling price		$              250	$             250	$              250	$              250	$             250
Operating ost		$              135	$             135	$              135	$              135	$             135
Sale		$                 -	$ 16,250,000	$ 16,250,000	$ 16,250,000	$ 16,250,000
Less: Operating Cost		$                 -	$   8,775,000	$    8,775,000	$    8,775,000	$   8,775,000
Contribution		$                 -	$   7,475,000	$    7,475,000	$    7,475,000	$   7,475,000
Less: Rent		$    3,100,000	$   3,100,000	$    3,100,000	$    3,100,000	$   3,100,000
Less: Depreciation (8,200,000/10)		$       820,000	$      820,000	$       820,000	$       820,000	$      820,000
Profit before tax (PBT)		$ (3,920,000)	$   3,555,000	$    3,555,000	$    3,555,000	$   3,555,000
Tax@35%	PBT*Tax rate	$ (1,372,000)	$   1,244,250	$    1,244,250	$    1,244,250	$   1,244,250
Profit After Tax (PAT)	PBT - Tax	$ (2,548,000)	$   2,310,750	$    2,310,750	$    2,310,750	$   2,310,750
Add Depreciation	PAT + Dep	$       820,000	$      820,000	$       820,000	$       820,000	$      820,000
Cash Profit after-tax		$ (1,728,000)	$   3,130,750	$    3,130,750	$    3,130,750	$   3,130,750
Calculation of NPV
						10.00%
Year		Capital		Operating cash	Annual Cash flow	PV factor, 1/(1+r)^time	Present values
0		$ (8,200,000)			$ (8,200,000)	1.0000	$ (8,200,000)
1				$ (1,728,000)	$ (1,728,000)	0.9091	$ (1,570,909)
2				$    3,130,750	$    3,130,750	0.8264	$    2,587,397
3				$    3,130,750	$    3,130,750	0.7513	$    2,352,179
4				$    3,130,750	$    3,130,750	0.6830	$    2,138,344
5		$    3,710,000		$    3,130,750	$    6,840,750	0.6209	$    4,247,568
					Net Present Value	$    1,554,578

Since Lab will be operational after 1 year, any sale will commence from Year 2 however, the lab is already rented so Depreciation will be charged in year 1. Similarly, depreciation will also be charged and the same is already installed.