Question

The company is considering the introduction of a new product that is expected to reach sales of $10 million in its first full year and $13 million of sales in the second and third years. Thereafter, annual sales are expected to decline to two-thirds of peak annual sales in the fourth year and one-third of peak sales in the fifth year. No more sales are expected after the fifth year. The CGS is about 60% of the sales revenues in each year. The GS&A expenses are about 23.5% of the sales revenue. Tax on profits is to be paid at a 40% rate. A capital investment of $0.5 million is needed to acquire production equipment. No salvage value is expected at the end of its five-year useful life. This investment is to be fully depreciated on a straight-line basis over five years. In addition, working capital is needed to support the expected sales in an amount equal to 27% of the sales revenue. This working capital investment must be made at the beginning of each year to build up the needed inventory and implement the planned sales program. Furthermore, during the first year of sales activity, a one-time product introductory expense of $200,000 is incurred. Approximately $1.0 million has already been spent promoting and test marketing the new product.

a. Formulate a multiyear income statement to estimate the cash flows throughout its five-year life cycle.

b. Assuming a 20% discount rate, what is the new product’s NPV?

c. Should the company introduce the new product?

Answer 1