Question

ZCM manufactures camera drones. The company currently has one existing model (ZC- 1G) on the market. Given the growing interest in aerial photography, the existing model (ZC- 1G) 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

The amount spent on survey and development are sunk costs and therefore should not be included in the cash flow analysis.

Operating cash flow (OCF) each year = income after tax + depreciation - investment in working capital - loss on in operating cash flow of ZC-1G model

In year 5, the entire working capital investment is recovered, and hence the investment in working capital is negative

profit on sale of equipment at end of year 5 = sale price - book value

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value - tax on profit on sale of equipment

NPV is calculated using NPV functions in Excel

NPV is $352,682

NPV is calculated using NPV functions in Excel

NPV is $352,682

Yes,  the company should proceed with the project as the NPV is positive

Yes,  the company should proceed with the project as the NPV is positive