Question

CASE 3               ZZ TOP TECHNOLOGY INC

CHAPTER 9

ZZ Top is a small technology company in Dublin, Ireland. The company started 70 years ago developing communication equipment for military organizations around the globe. The company, in a desire to diversify, has developed a reputation in specialty communication equipment to consumers. ZZ has developed a new smart phone that can do all things an Apple iphone can do, but has added an impressive array of medical tests, such as EKG and heart rate, that are available instantly to the owner of their smart phone.

You have just graduated from Lee and are interviewing with ZZ for a job in their Finance Department. ZZ has an unusual interview process. Rather than a face-to-face meeting, ZZ has sent you details of the proposed new smart phone project. If you can calculate the NPV, IRR and Payback Period of this project you will be hired at a very handsome salary.

The details of the project include spending $1.2 million to develop a prototype and $250,000 for a marketing study to determine expected sales. ZZ can manufacture the new phone for $210 variable costs. Fixed costs for the project will be $5.3M per year. The estimated sales volumes are 64,000, 106,000, 87,000, 78,000, and 54,000 per year for each of the next five years. The unit price of the new phone will be $515. The equipment necessary to do the project will cost $38.5M and will be depreciated using the straight-line method. It is thought that the value of the equipment will have a value of $5.8M at the end of the project. Initial NWC is $250,000 and will then be 20% of sales for each of the project’s five years.  

ZZ has a corporate tax rate of 22% and a required return of 12%.

To get the job, ZZ has asked you to develop a Pro Forma Cash Flow statement on an Excel spreadsheet and calculate the IRR, NPV, and Payback period for this project. You must submit this next Tuesday, April 14 to your Finance professor by email who will grade them and send results to ZZ Top.

Answer 1

We will first calculate the Net Income from given Data as per the following table

	T=0	T=1	T=2	T=3	T=4	T=5	Explanation
No. of Units sold		64,000	106,000	87,000	78,000	54,000	Given Data
Per unit price		515	515	515	515	515	Given Data
Sales Revenue		32,960,000	54,590,000	44,805,000	40,170,000	27,810,000	Revenue = No of Units sold x Price
Fixed Costs		5,300,000	5,300,000	5,300,000	5,300,000	5,300,000	Given Data
Variable Costs @210 per unit		13,440,000	22,260,000	18,270,000	16,380,000	11,340,000	Variable Cost = Number of units sold x $210 (Given data)
Depreciation		7,990,000	7,990,000	7,990,000	7,990,000	7,990,000	Depreciation is SLM and the equipment has to be depreciated for 3 years> The cost would include cost of developing prototype, marketing study &equipment cost = 39950000/3       = 13,316,667
Net Operating Income		6,230,000	19,040,000	13,245,000	10,500,000	3,180,000	Net Operating Revenue = Sales Revenue - Costs - Depreciation
Tax @ 22%		1,370,600	4,188,800	2,913,900	2,310,000	699,600	Tax at the rate of 22%
Net Income		4,859,400	14,851,200	10,331,100	8,190,000	2,480,400	Net Income = NOI - Taxes

We will then calculate the net cash flows as per the table below :

Cash Flows	T=0	1	2	3	4	5	Explanation
(-) Cost of Developing the prototype	(1,200,000.00)						Cost of developing prototype in Yr 0 is 1,200,000. A negative sign indicates cash out flow
(-) Cost of Marketing Study	(250,000.00)						Cost of Marketing Study in Yr 0 is 250,000. A negative sign indicates cash out flow
(-) Equipment Cost	(38,500,000.00)						Cost of Equipment in Yr 0 is 38,500,000. A negative sign indicates cash out flow
(+) Net Income		4,859,400	14,851,200	10,331,100	8,190,000	2,480,400	From Net Income Above
(+) Depreciation		7,990,000	7,990,000	7,990,000	7,990,000	7,990,000	From Depreciation Above
(+-) Change in Working Capital		250,000	6,342,000	4,326,000	(1,957,000)	(927,000)	This is the difference in Net Working Capital from previous year
Net Cash Flow of Project*	(39,950,000)	12,599,400	16,499,200	13,995,100	18,137,000	11,397,400	Net Cash Flow = Cost of Fixed Asset + Net Income + Depreciation - Increase in working Capital

Net Working Capital

250,000

6,592,000

10,918,000

8,961,000

8,034,000

5,562,000

Working Capital = 20% x Revenue of Year

*Not included the After Tax Market value of equipment at the end of 5 years in Cash Flow calculation, as not clear if it is to be disposed / sold and cash realised.

Using these Net Cash Flows for IRR

Year	Net Cash Flow of Project
0	(39,950,000)
1	12,599,400
2	16,499,200
3	13,995,100
4	18,137,000
5	11,397,400
IRR	23.81%

WE calculated IRR from Excel formula

We next calculate NPV using the net cash flows

Discount Rate	12%
Year	Net Cash Flow of Project	PV of Cash Flows	Explanation for PV
0	(39,950,000)	(39,950,000)	=39950000/(1+12%)^0
1	12,599,400	11,249,464	=12599400/(1+12%)^1
2	16,499,200	13,153,061	=16499200/(1+12%)^2
3	13,995,100	9,961,436	=13995100/(1+12%)^3
4	18,137,000	11,526,391	=18137000/(1+12%)^4
5	11,397,400	6,467,191	=11397400/(1+12%)^5
	NPV	12,407,543

We will calculate the Pay Back period as below

Year	Net Cash Flow of Project	Cumulative Pay Back
0	(39,950,000)	(39,950,000)
1	12,599,400	(27,350,600)
2	16,499,200	(10,851,400)
3	13,995,100	3,143,700
4	18,137,000	21,280,700
5	11,397,400	32,678,100

The pay back is between 2 & 3 years

Pay Back Period = 2 + (10851400/13995100) = 2.78 Years