Question

TechCorp is a company that is a leader in statistical software industry. TechCorp has only one product: Stata. TechCorp’s current sales is $10 million, and it expects the sales to stay the same. TechCorp is now considering launching a new product X-Cross. The company has already spent $1 million to hire Mays Consulting Group to perform a detailed business analysis. Mays Consulting Group found out the following facts:

• If TechCorp decides to launch X-Cross, it will need to pay $1 million royalty fees each year for the next three years (year 1, 2, and 3). Royalty fees are not included in either COGS or SG&A.

• TechCorp will be able to sell X-Cross for the next three years. The revenue of X-Cross is estimated to be $8 million each year. Production and sales of X-Cross will end after that.

• The production cost (including both COGS and SG&A) of X-Cross is expected to be 25% of its sales, while the production cost (including both COGS and SG&A) of the Stata is 20% of its sales. Introduction of X-Cross will reduce the sales of Stata by 25% in each of the three years when X-Cross is on the market.

• In order to produce X-Cross, TechCorp needs to invest $8 million in supercomputers now (i.e., in Year 0). These supercomputers can be only used for the X-Cross project and their value will be depreciated to zero using 4-year straight line depreciation schedule.

• TechCorp’s level of net working capital has always been maintained at a constant level, which is $1 million. The X-Cross project will require the net working capital to be $3 million, $2 million, and $1 million in year 1, 2 and 3, respectively. The level of net working capital will be $1 million after year 3.

• Tax rate is 35% and the project’s cost of capital is 10%.

Perform the capital budgeting analysis for TechCorp’s X-Cross project and calculate its NPV

Answer 1

		Present value of Cash flow=(Cash flow)/((1+i)^N)
		i=discount rate=cot of capital=10%=0.10
		N=year of Cash Flow
		ANALYSIS OF CASH FLOW
		Cost of consulting $1million is a sunkcost and not relevant for this analysis
		Initial Cash Flow:
		Cost of Super computer	$8,000,000
		Depreciation Expenses:
		Year	1	2	3	4
	A	MACRS Depreciation Rate	33.33%	44.45%	14.81%	7.41%
	B=A*8000000	Annual Depreciation	$2,666,400	$3,556,000	$1,184,800	$592,800
		Reduction in contribution from STATA
		Reduction in sales=25%*10 million	$2,500,000
		Reduction in Costs=20%*2500000	$500,000
		Reduction in before tax profit	$2,000,000
		Annual Cash Flow:
	N	Year	1	2	3	4
	a	Sales Revenue	$8,000,000	$8,000,000	$8,000,000
	b	Royalty Fees	-$1,000,000	-$1,000,000	-$1,000,000
	c=25%*a	Production cost	($2,000,000)	($2,000,000)	($2,000,000)
	d	Depreciation expenses	($2,666,400)	($3,556,000)	($1,184,800)	($592,800)
	e	Reduction in profit from existing product	($2,000,000)	($2,000,000)	($2,000,000)
	f=a+b+c+d+e	Profit before tax	$333,600	($556,000)	$1,815,200	($592,800)
	g=f*35%	Tax expense/(Savings)	$116,760	($194,600)	$635,320	($207,480)
	h=f-g	After tax profit	$216,840	($361,400)	$1,179,880	($385,320)
	i	Add: Depreciation (non cash expense)	$2,666,400	$3,556,000	$1,184,800	$592,800
	j=h+i	Operating Cash Flow	$2,883,240	$3,194,600	$2,364,680	$207,480
	k	Working Capital Need	$3,000,000	$2,000,000	$1,000,000	$1,000,000
	l	Working Capital Cash Flow	($2,000,000)	$1,000,000	$1,000,000	$0
	CF=j+l	TotalCash Flow	$883,240	$4,194,600	$3,364,680	$207,480	SUM
	PV=CF/(1.1^N)	Present Value of Cash Flow	$802,945	$3,466,612	$2,527,934	$141,712	$6,939,203
	PV	Sum of Present Values of Cash inflows	$6,939,203
	I	Initial Cash Flow	($8,000,000)
	NPV=PV+I	Net Present Value	($1,060,797)