Question

Englewood Company has an opportunity to produce and sell a revolutionary new smoke detector for homes. To determine whether this would be a profitable venture, the company has gathered the following data on probable costs and market potential:

New equipment would have to be acquired to produce the smoke detector. The equipment would cost $100,000 and be useable for 12 years. After 12 years, it would have a salvage value equal to 10% of the original cost.

Production and sales of the smoke detector would require a working capital investment of $40,000 to finance accounts receivable, inventories, and day-to-day cash needs. This working capital would be released for use elsewhere after 12 years.

An extensive marketing study projects sales in units over the next 12 years as follows:

Year                Sales in Units

                        1……………. 4,000

                        2……………. 7,000

                        3……………. 10,000

                        4-12………… 12,000

The smoke detectors would sell for $45 each; variable costs for production, administration, and sales would be $25 per unit.

To gain entry into the market, the company would have to advertise heavily in the early years of sales. The advertising program follows:

Amount of Yearly

Year                      Advertising

1-2…………. $70,000

3…………… $50,000

4-12………..   $40,000

Other fixed costs for salaries, insurance, maintenance, and straight-line depreciation on equipment would total $127,500 per year. (Depreciation is based on cost less salvage value.)

The company’s required rate of return is 20%

Required:

(6 points) Compute the net cash inflow (cash receipts less yearly cash operating expenses) anticipated from the sale of the smoke detectors for each year over the next 12 years.

(4 points) Using the data computed in (1) above and other data provided in the problem, determine the net present value of the proposed investment. Would you recommend that Englewood Company accept the smoke detector as a new product?

Answer 1

Net cash flows
			Year-1	Year-2	Year-3	Year 4-6
Sales units			4000	7000	10000	12000
Selling price per unit			45	45	45	45
Less: Variable cost per unit			25	25	25	25
Contribution margin per unit			20	20	20	20
Contribution margin earned			80000	140000	200000	240000
Less: Other fixed cost excl. dep			120000	120000	120000	120000
(127500-7500)
Less: Advertisement expense			70000	70000	50000	40000
Net cash flows			-110000	-50000	30000	80000
Net present value
			Year-0	Year-1	Year-2	Year-3	Year-4	Year5	Year-6
Initial investment			-100000
Working capital			-40000
Cash flows				-110000	-50000	30000	80000	80000	80000
Release of working capiptal									40000
Salvage value									10000
Net cash flows			-150000	-110000	-50000	30000	80000	80000	130000
PVF @ 20%			1	0.833333	0.694444	0.578704	0.482253	0.401878	0.334898
Present value of cash flows			-150000	-91666.7	-34722.2	17361.11	38580.25	32150.21	43536.74
NPV			-144760
No, Company should not accept the order.