A projection for a new product line was prepared by a task force from Engineering and...

A projection for a new product line was prepared by a task force from Engineering and Sales. The plan presented to management calls for an initial investment of $13,000,000 which is projected to generate annual revenue which increases at $750,000 per year, with a first year revenue of $5,000,000. Annual costs which are estimated at $2,750,000 for the first year, are expected to increase in direct proportion to the annual revenue. The task force has made a case for a 10 year study period, which managment has accepted. Calculate the annual rate of return (ROI) for this projection. The company uses a MARR of 12%. Is the project attractive?

During the task force's presentation, serious doubt is expressed by management about the first year cost estimate, the opinion is that it is too low. Management accepts the cost estimates for years 2 through 10. How large could the first year cost estimate be and still meet the 12% MARR?

In a second response to management's skepticism about the first year cost, the task force pointed out that the annual cost estimates do not include a learning and experience factor. THis has always been in excess of 5% for the company. Assuming that management accepts the sales pronections and the same annual cost reduction of 5%(for each year), what would be the ROI when this annual cost reduction is applied?

Expert Solution

Outflows	Revenue	Cost	Net Flows
(13,000,000.00)			(13,000,000.00)
	5,000,000.00	2,750,000.00	2,250,000.00
	5,750,000.00	3,162,500.00	2,587,500.00
	6,500,000.00	3,575,000.00	2,925,000.00
	7,250,000.00	3,987,500.00	3,262,500.00
	8,000,000.00	4,400,000.00	3,600,000.00
	8,750,000.00	4,812,500.00	3,937,500.00
	9,500,000.00	5,225,000.00	4,275,000.00
	10,250,000.00	5,637,500.00	4,612,500.00
	11,000,000.00	6,050,000.00	4,950,000.00
	11,750,000.00	6,462,500.00	5,287,500.00
IRR			21%

IRR = 21%

Calculated using Trial and Error Method. (Inflow =Outflow)

Yes, the project is attractive.

Part B:

Outflow =	Present Value of Inflows
13000000=	(5000000-Cost)*0.892857142857143+17539828
(13000000-17539828.23)/0.892857142857143	(5000000-Cost)	5084608.174
Cost	5000000+5084607 =	10084607

Note:

Calculation Table:?

	Outflows	Revenue	Cost	Net Flows	Discountin Factor	Present Value
0	(13,000,000.00)			(13,000,000.00)
1		5,000,000.00	Cost	5000000-Cost	0.892857143	(5000000-Cost)*0.892857142857143
2		5,750,000.00	3,162,500.00	2,587,500.00	0.797193878	2,062,739.16
3		6,500,000.00	3,575,000.00	2,925,000.00	0.711780248	2,081,957.22
4		7,250,000.00	3,987,500.00	3,262,500.00	0.635518078	2,073,377.73
5		8,000,000.00	4,400,000.00	3,600,000.00	0.567426856	2,042,736.68
6		8,750,000.00	4,812,500.00	3,937,500.00	0.506631121	1,994,860.04
7		9,500,000.00	5,225,000.00	4,275,000.00	0.452349215	1,933,792.90
8		10,250,000.00	5,637,500.00	4,612,500.00	0.403883228	1,862,911.39
9		11,000,000.00	6,050,000.00	4,950,000.00	0.360610025	1,785,019.62
10		11,750,000.00	6,462,500.00	5,287,500.00	0.321973237	1,702,433.49
						17,539,828.23

ROI when this annual cost reduction:

	Outflows	Revenue	Cost	Net Flows
0	(13,000,000.00)			(13,000,000.00)
1		5,000,000.00	2,750,000.00	2,250,000.00
2		5,750,000.00	3,004,375.00	2,745,625.00
3		6,500,000.00	3,396,250.00	3,103,750.00
4		7,250,000.00	3,788,125.00	3,461,875.00
5		8,000,000.00	4,180,000.00	3,820,000.00
6		8,750,000.00	4,571,875.00	4,178,125.00
7		9,500,000.00	4,963,750.00	4,536,250.00
8		10,250,000.00	5,355,625.00	4,894,375.00
9		11,000,000.00	5,747,500.00	5,252,500.00
10		11,750,000.00	6,139,375.00	5,610,625.00
	IRR			23%

ROI = 23%

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