In: Accounting
Jericho Manufacturing developed a new wireless phone charger which also uses the excess heat generated during the process to keep your coffee warm at a predetermined temperature. The company is anxious to begin production of the new charger. To this end, marketing and cost studies have been made to determine probable costs and market potential. These studies have provided the following information:
New equipment would have to be acquired to produce the device. The equipment would cost $315,000 and have a 12-year useful life. After 12 years, it would have a salvage value of about $15,000.
Sales in units over the next 12 years are projected to be as follows:
Year |
Sales in Units |
1 |
6,000 |
2 |
12,000 |
3 |
15,000 |
4-12 |
18,000 |
Production and sales of the charger would require working capital of $60,000 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 $35 each; variable costs for production, administration, and sales would be $15 per unit.
Fixed costs for salaries, maintenance, property taxes, insurance, and straight-line depreciation on the equipment would total $135,000 per year. The depreciation is based on cost less salvage value.
To gain rapid entry into the market, the company would have to advertise heavily. The advertising program would be:
Year |
Annual Advertising Expenses |
1-2 |
$180,000 |
3 |
$150,000 |
4-12 |
$120,000 |
The company’s board of directors has specified a required rate of return of 14% on all new products.
Requirements (Ignore income taxes)
You have been asked by your boss to evaluate the charger proposal from a capital budgeting perspective. You are to analyze the above data and prepare a memo to your boss recommending whether or not the company should accept the charger as a new product (5 points). Supplemental tables should be included in your memo as necessary to explain amounts included in the memo and support your recommendation.
As part of your evaluation, you should perform the following at a minimum.
Compute the net cash inflow (cash receipts less yearly cash operating expenses) anticipated from sale of the device for each year over the next 12 years. A table supporting this computation should be included. (10 points)
Using the data computed in (1) above and other data provided in the problem, determine each of the following for the proposed investment. Tables supporting each computation should be included as part of your memo, as necessary.
Net present value (10 points)
Internal rate of return (10 points)
Payback period (10 points)
in the memo the proposal is rejected as net present value is negative . the caculation given below
Ans
Following assumptions are taken for calculating the net cash inflow (cash receipts less yearly cash operating expenses)
Depreciation per year = ( cost of equipment – salvage value ) /total useful year
=( $315,000-$15,000)/12
=$300,000/12
=$25,000
The Calculation of the net cash inflow (cash receipts less yearly cash operating expenses) anticipated from sale of the device for each year over the next 12 years.
Is given below
year |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
10 |
11 |
12 |
sales in unit |
6000 |
12000 |
15000 |
18000 |
18000 |
18000 |
18000 |
18000 |
18000 |
18000 |
18000 |
18000 |
selling price per unit |
35 |
35 |
35 |
35 |
35 |
35 |
35 |
35 |
35 |
35 |
35 |
35 |
Net sales in $ |
210000 |
420000 |
525000 |
630000 |
630000 |
630000 |
630000 |
630000 |
630000 |
630000 |
630000 |
630000 |
less -Variable cost @$15 |
90000 |
180000 |
225000 |
270000 |
270000 |
270000 |
270000 |
270000 |
270000 |
270000 |
270000 |
270000 |
Contribution |
120000 |
240000 |
300000 |
360000 |
360000 |
360000 |
360000 |
360000 |
360000 |
360000 |
360000 |
360000 |
Less- fixed cost |
135000 |
135000 |
135000 |
135000 |
135000 |
135000 |
135000 |
135000 |
135000 |
135000 |
135000 |
135000 |
less-advertising cost |
180000 |
180000 |
150000 |
120000 |
120000 |
120000 |
120000 |
120000 |
120000 |
120000 |
120000 |
120000 |
net income |
-195000 |
-75000 |
15000 |
105000 |
105000 |
105000 |
105000 |
105000 |
105000 |
105000 |
105000 |
105000 |
Add-depreciation |
25000 |
25000 |
25000 |
25000 |
25000 |
25000 |
25000 |
25000 |
25000 |
25000 |
25000 |
25000 |
Cash inflow/(outflow) |
-170000 |
-50000 |
40000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
Let us calculate the NPV . the following assumptions are made
The cost of capital or required return is 14% the present value factor will be 14%
The working capital required at year 0 will be $60,000 and will be recovered at year 12
The net present value is calculated as under
calculation of NPV |
|||||||||||||
year |
0 |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
10 |
11 |
12 |
cost of new equipment |
-315000 |
||||||||||||
working capital required |
-60000 |
||||||||||||
Total cash ouflow |
-375000 |
0 |
0 |
0 |
0 |
0 |
0 |
0 |
0 |
0 |
0 |
0 |
0 |
cash receipts inflow/outflow |
-170000 |
-50000 |
40000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
|
salvage value |
15000 |
||||||||||||
working capital |
60000 |
||||||||||||
total cash inflow |
0 |
-170000 |
-50000 |
40000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
205000 |
net cash flow (inflow-outflow) |
-375000 |
-170000 |
-50000 |
40000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
130000 |
205000 |
PV @14% |
1 |
0.877193 |
0.769468 |
0.674972 |
0.59208 |
0.519369 |
0.455587 |
0.399637 |
0.350559 |
0.307508 |
0.269744 |
0.236617 |
0.207559 |
net cash inflow at present value factor |
-375000 |
-149123 |
-38473 |
26999 |
76970 |
67518 |
59226 |
51953 |
45573 |
39976 |
35067 |
30760 |
42550 |
cumulative NPV |
-375000 |
-524123 |
-562596 |
-535597 |
-458627 |
-391109 |
-331883 |
-279930 |
-234357 |
-194381 |
-159314 |
-128554 |
-86005 |
The net present value ($86,005) means the cash outflow is more than inflow at required rate of return of 14% hence the proposal is rejected
Calculation of IRR
internal Rate of Return is the interest rate that makes the Net Present Value zero.
As per IRR calculator the rate is 11.23% per annum
Calculation of payback period
The following points are to be noted
The investment in equipment is net of salvage value is $300,000
The working capital will be added in cash outflow for calculation in payback period which is $60,000
The total cashflow at year Zero is $360,000 and calculate at what period this amount is recovered
The cumulative cashflow is calculated as below
payback period |
||
year |
net cashflows |
cumlative cash inflow |
1 |
-170000 |
-170000 |
2 |
-50000 |
-220000 |
3 |
40000 |
-180000 |
4 |
130000 |
-50000 |
5 |
130000 |
80000 |
6 |
130000 |
210000 |
7 |
130000 |
340000 |
8 |
130000 |
470000 |
9 |
130000 |
600000 |
10 |
130000 |
730000 |
11 |
130000 |
860000 |
12 |
130000 |
990000 |
Payback period is = year7 +(20,000/130,000)
=7 +0.1538
Payback years is 7.1538 years