Question

Matheson Electronics has just developed a new electronic device that it believes will have broad market appeal. The company has performed marketing and cost studies that revealed the following information:

New equipment would have to be acquired to produce the device. The equipment would cost $480,000 and have a six-year useful life. After six years, it would have a salvage value of about $12,000.

Sales in units over the next six years are projected to be as follows:

Year	Sales in Units
1	15,000
2	20,000
3	22,000
4–6	24,000

Production and sales of the device would require working capital of $61,000 to finance accounts receivable, inventories, and day-to-day cash needs. This working capital would be released at the end of the project’s life.

The devices would sell for $60 each; variable costs for production, administration, and sales would be $45 per unit.

Fixed costs for salaries, maintenance, property taxes, insurance, and straight-line depreciation on the equipment would total $155,000 per year. (Depreciation is based on cost less salvage value.)

To gain rapid entry into the market, the company would have to advertise heavily. The advertising costs would be:

Year	Amount of Yearly Advertising
1–2	$	218,000
3	$	70,000
4–6	$	60,000

The company’s required rate of return is 15%.

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. Compute the net cash inflow (incremental contribution margin minus incremental fixed expenses) anticipated from sale of the device for each year over the next six years.

2-a. Using the data computed in (1) above and other data provided in the problem, determine the net present value of the proposed investment.

2-b. Would you recommend that Matheson accept the device as a new product?

Answer 1

Initial Investment                            =             $480000

Working Capital Required             =             $61000

Total Cash Outflow                         =             $541000

Depreciation

= (Equipment Cost – Salvage Value)/No. of Useful Life

= ($480000 - $12000) / 6

= $78000

COMPUTATION OF FUTURE CASH INFLOWS
Particulars	Year 1	Year 2	Year 3	Year 4-5	Year 6
Units	15000	20000	22000	24000	24000
Sales ($60)	$     900,000	$ 1,200,000	$ 1,320,000	$ 1,440,000	$ 1,440,000
Less:
Variable Cost ($45)	$     675,000	$     900,000	$     990,000	$ 1,080,000	$ 1,080,000
Fixed Cost	$     155,000	$     155,000	$     155,000	$     155,000	$     155,000
Advertising Expense	$     218,000	$     218,000	$        70,000	$        60,000	$        60,000
Total Expenses	$ 1,048,000	$ 1,273,000	$ 1,215,000	$ 1,295,000	$ 1,295,000
Profit Before & After Tax	$   (148,000)	$     (73,000)	$     105,000	$     145,000	$     145,000
Add: Depreciation	$        78,000	$        78,000	$        78,000	$        78,000	$        78,000
Add: Working Capital					$        61,000
Add: Salvage Value					$        12,000
Cash Inflows	$     (70,000)	$          5,000	$     183,000	$     223,000	$     296,000

2.A)          

Year	Cash Inflow	PVF @ 15%	Total Present Value
1	$     (70,000)	0.870	$                      (60,900)
2	$         5,000	0.756	$                          3,780
3	$     183,000	0.658	$                      120,414
4	$     223,000	0.572	$                      127,556
5	$     223,000	0.497	$                      110,831
6	$     296,000	0.432	$                      127,872
	Present Value Of Cash Inflow		$                      429,553
	Less: Initial Investment		$                   (480,000)
	NPV		$                      (50,447)

               

b)            I would not recommend that Matheson accept the device as a new product because Net Present Value of the new device is in negative which means that cash outflows is more than cash inflows. The new device wouldn’t be able to generate enough profit to eliminate the cash outflow.