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Question: Electronics Unlimited was considering the introduction of a new product that was expected to reac...

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Electronics Unlimited was considering the introduction of a new product that was expected to reach sales of $10 million in its first full year, and $13 million of sales in the second year. Because of intense competition and rapid product obsolescence, sales of the new product were expected to remain unchanged between the second and third years following introduction. Thereafter, annual sales were expected to decline to two-thirds of peak annual sales in the fourth year, and one-third of peak sales in the fifth year. No material levels of revenues or expenses associated with the new product were expected after five years of sales. Based on past experience, cost of sales for the new product were expected to be 60% of total annual sales revenue during each year of its life cycle. Selling, general, and administrative expenses were expected to be 23.5% of total annual sales. Taxes on profits generated by the new product would be paid at a 40% rate.

To launch the new product, Electronics Unlimited would have to incur immediate cash outlays of two types. First, it would have to invest $500,000 in specialized new production equipment. This capital investment would be fully depreciated on a straight-line basis over the five-year anticipated life cycle of the new product. It was not expected to have any material salvage value at the end of its depreciable life. No further fixed capital expenditures were required after the initial purchase of equipment.

Second, additional investment in net working capital to support sales would have to be made. Electronics Unlimited generally required 27¢ of net working capital to support each dollar of sales. As a practical matter, this buildup would have to be made by the beginning of the sales year in question (or, equivalently, by the end of the previous year). As sales grew, further investments in net working capital ahead of sales would have to be made. As sales diminished, net working capital would be liquidated and cash recovered. At the end of the new product’s life cycle, all remaining net working capital would be liquidated and the cash recovered.

Finally, Electronics Unlimited expected to incur tax-deductible introductory expenses of $200,000 in the first year of the new product’s sales. These costs would not be recurring over the product’s life cycle. Approximately $1.0 million had already been spent developing and test marketing the new product. These expenditures were also one-time expenses that would not be recurring during the new product’s life cycle.

A. Estimate the new product’s future sales, profits, and cash flows throughout its five-year life cycle.

B. Assuming a 20% discount rate, what is the product’s net present value? (Except for changes in net working capital, which must be made before the start of each sales year, you should assume that all cash flows occur at the end of the year in question.) What is its internal rate of return?

C. Should Electronics Unlimited introduce the new product?

Answer 1

A. Depreciation = (Initial Cost - Salvage Value) / No of Years = (500000 - 0) / 5 = 100000

Operating profit (EBIT) = Sales - Cost of sales - selling, general and administrative expenses - depreciation

After tax Operating Cash flow = Operating Profit ( 1- tax rate) + Depreciation

Sales in Year 4 = 2/3 of peak sales = 2/3 of sales in year 3 = (2/3 ) x 13000000 = 8666666.67

Sales in Year 5 = 1/3 of peak sales = 1/3 of sales in year 3 = (1/3 ) x 13000000 = 4333333.33

Calculation of After tax Operating Cash Flows
	Year 1	Year 2	Year 3	Year 4	Year 5
Sales	10000000.00	13000000.00	13000000.00	8666666.67	4333333.33
Cost of Sales (60% of Sales)	6000000.00	7800000.00	7800000.00	5200000.00	2600000.00
SG&A Expenses (23.5% of Sales)	2350000.00	3055000.00	3055000.00	2036666.67	1018333.33
Depreciation	100000.00	100000.00	100000.00	100000.00	100000.00
Operating Profit (EBIT)	1550000.00	2045000.00	2045000.00	1330000.00	615000.00
EBIT (1-Tax rate)=EBIT(1-40%)	930000.00	1227000.00	1227000.00	798000.00	369000.00
Plus : Depreciation	100000.00	100000.00	100000.00	100000.00	100000.00
After tax Operating Cash Flows	1030000.00	1327000.00	1327000.00	898000.00	469000.00

Cash flow from Incremental Investment in Net Working Capital required at beginning of the year = - 27 cents for a dollar sales in the year = - 27% of sales for the year

Cash flow from Incremental Investment in Net Working capital at beginning of year = (Sales for the year - Sales for previous year) x - 27%

For example,Cash flow from investment in Net working capital in year 0 or beginning of year 1 = (Sales for year 1 - Sales for year 0) x - 27% = (10000000 - 0) x -27% = - 2700000

Cash flow from Investment in Net working capital in year 4 or beginning of year 5 = (Sales for year 5 - Sales for year 4) x -27% = (4333333.33 - 8666666.67) x - 27% = 1170000 ie net working capital has been liquidated as sales have declined

Similarly, Cash flow from Investment in Net Working Capital can be found out for other years

Calculation of Investment in Working Capital
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Sales	0	10000000.00	13000000.00	13000000.00	8666666.67	4333333.33	0
Cash Flow from Investment in Net Working Capital	-2700000.00	-810000.00	0.00	1170000.00	1170000.00	1170000.00

Cash flow from tax deductible introductory expenses in year 1 = - 200000 ( 1- tax rate) = -200000 x ( 1-40%) = -120000

$1 million invested in developing and test marketing the product should be ignored since it is a sunk cost.

Calculation of Net Cash Flows
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Fixed Investment	-500000
After Tax Operating Cash Flows		1030000	1327000	1327000	898000	469000
Cash Flow from Investment in Net Working Capital	-2700000	-810000	0	1170000	1170000	1170000
Tax Deductible introductory expenses		-120000
Net Cash Flow	-3200000	100000	1327000	2497000	2068000	1639000

B. Net Present Value = Net Cash flow in year 0 + present value of Net cash flows from year 1 to 5 discounted at 20%

= -3200000 + 100000/(1+20%) + 132700/(1+20%)² + 249700/(1+20%)³ + 206800/(1+20%)⁴ + 163900/(1+20%)⁵

= -3200000 + 83333.33 + 921527.78 + 1445023.15 + 997299.38 +658677.34 = 905860.98

Calculation of IRR

We will find the IRR such by solving the equation using IRR fuction in excel

0 = -3200000 + 100000/(1+IRR) + 132700/(1+IRR)² + 249700/(1+IRR)³ + 206800/(1+IRR)⁴ + 163900/(1+IRR)⁵

Formula to be used : = IRR(Cash flows)

Using IRR function in excel we get, IRR = 29.55%

C.Since the product has positive net present value, therefore product should be introduced.