Question

Company has grown from a local electronics retail store to one of leading manufacturers and distributor of navigation equipment in only five years. Today, Majid is meeting with the company’s head of marketing, Omar Al Mansoor, to discuss the development of a new product, the Map100, a new generation system with detailed Middle East road and sea area coverage for driving, boating, or plain walking applications. The new interface of the Map100 allows for an automatic update of the road system and the area’s general infrastructure without the inconvenience of a manual download of new maps. Omar’s department has conducted extensive market research to gauge potential demand for the new product and to sense the amount of money potential customers are likely to pay for the Map100 features. Based on these findings, Omar and his team are convinced that at a price of LL 202,500 ($ 135) per unit, 15,000 Map100s could be sold the first year. With an aggressive marketing campaign, second-year sales could be boosted to 16,000 units. Unfortunately, barriers to entry are quite low and new rivals are expected to increase product supply significantly. As a result, sales are likely to go down by 500 units in year 3 and 4 after which the annual sales decrease accelerates to 1,000 units. The resulting revenue reduction is amplified by an annual unit price decrease of 3 percent after year 2. Variable costs per unit are LL 70,500 ($ 47) for the first year and estimated to increase by 4 percent per year. First-year annual fixed costs are set at LL 600 million ($ 400,000) but are likely to go up by LL 15 million ($ 10,000) per year. The recommended investment period is only 6 years, mainly because of the anticipated reduction in profit margins as a result of a combination of heightened competition and inflationary pressure. The initial investment of LL 3.6 billion ($ 2.4 million), for the production equipment, will be depreciated according to the 7-year asset class MACRS schedule. With the launch of the project, an immediate net working capital investment of LL 337.5 million ($ 225,000) will be required. As the financial analyst of the company, Majid has asked you to join the meeting. Based on your estimate of company cost of capital of 11.5 percent, you perform the following tasks:

QUESTIONS:

1.            Generate pro-forma income statements for years 1-6 and determine the resulting annual operating cash flows. Assume a corporate tax rate of 15 percent.

2.            Compute the annual expected net cash flow for year 1-6, assuming that the net working capital investment will be necessary right away and that it will be recovered in full at the end of year 6. At the end of the project’s intended life (year 6) the production equipment is expected to be sold at its book value.

3.            Determine the payback period using the simple and the discounted method. Do you suggest going ahead with the project?

4.            Apply the NPV, IRR, and MIRR method to the computed net cash flows and interpret your results. Also compute the profitability index. Do your results support your earlier conclusions about the project’s profitability?

Answer 1