Question

The Alpha Dog Company manufactures and distributes a variety of pet-related products. In response to customer feedback relating to the fragile nature of many commercially available dog leashes, the company’s product development team has recently introduced a prototype of a new, virtually indestructible dog leash. The development of the prototype cost $250,000 in research and development costs. The product development team has presented their proposal to Adam Smith, the company’s president and CEO.

Adam has asked you, as the chief financial officer, to prepare an analysis of the proposal and to provide a decision regarding whether or not to pursue to proposal.

Your first step in the analysis was to commission a market survey to assess the potential demand for the new product. You hired a consulting firm, Williams and Connelly, at a flat rate of $100,000 to conduct this market research. The results of their study indicate that potential consumers would be willing to pay upwards of $75 per dog leash, on the presumption that it truly is indestructible. It is further estimated that Alpha will have this segment of the market virtually all to itself for 5 years, at which time it is believed the market will have become saturated and that sales of the new leash will cease. The market study indicates that unit sales volume for this period will evolve as follows;

Year	Unit Sales
1	10,000
2	15,000
3	25,000
4	20,000
5	5,000

After assessing the market demand potential, your turn to the head of your manufacturing department, John Williams, to consider the operating costs of producing the new dog leash. John believes that it will be necessary to purchase some new manufacturing equipment for the new product. After calling several potential suppliers, John thinks that the best deal on the necessary equipment will cost Alpha $1.5 million. For tax purposes, this equipment will be classified under the 3-years MACRS classification. John also estimated that the variable costs of production, such as raw materials and labor, will cost about $35 per unit and that the fixed costs of production will run another $150,000 per year. Finally, John thinks that a reasonable estimate of the resale value of the production equipment will be about $300,000 5 years from now.

Next, you consult with Alpha’s marketing department to evaluate any potential impact on existing leash models. Janet Mellon, the head of the market department, thinks that the introduction of this new and improved product will take some sales away from its current top-of-the-line dog leash. If Alpha does not go ahead with the new product introduction, it is believed that its existing dog leash will sell for $45 per leash and that unit sales volume will be 8,000 units per year for the next 5 years. The production costs of the existing model have been established as $15 per unit in variable costs and fixed production costs of $200,000 per year. If Alpha were to go ahead with the new leash project, is has been estimated that unit sales of its existing product will decline to 5,000 units per year for the next 5 years. Additionally, Janet thinks that, in order to reach this sales volume, it will be necessary to reduce the selling price of the existing leash by $5 per unit.

Finally, based on Alpha’s past experience with new product introductions, you estimate that, at inception of the project, Alpha will need to invest $400,000 in inventory to support the anticipated sales volume. Of this amount, $200,000 will be financed by taking on additional short-term liabilities (i.e. buying inventory on credit). It is assumed that this working capital investment will be fully recovered at the end of the project’s 5-year horizon. Alpha pays income taxes at a marginal rate of 40% and assigns a required return of 10% to new product proposals.

Adam has asked you to prepare a forecast of the cash flows to be generated from this project to be used in his final evaluation. Be sure to determine operating cash flow, capital expenditures, changes in net working capital, and cash flow from assets (CFA) for each year.

(You may want to use the templates on the following page.)

Revenues	Year 1	Year 2	Year 3	Year 4	Year 5
New Sales Volume
Sales Price
New Sales Revenue
Lost Sales Volume
Lost Sales Price
Lost Sales Revenue
Existing Price Impact
Total Lost Revenues
Net Sales Revenue
Costs
Unit Variable Costs
Total Variable Costs
Avoided Variable Costs
Net Variable Costs
Income Statement (Pro-forma)	Year 1	Year 2	Year 3	Year 4	Year 5
Sales Revenue
Variable Costs (net)
Fixed Costs
Depreciation
EBIT
Taxes
Net Income

Cash Flows	0	1	2	3	4	5
Operating Cash Flow
Net Working Capital Investment
Capital Expenditures
Net Salvage Value
Cash Flow from Assets

Calculate the net present value of the proposed project.

Do you recommend undertaking this project? Why or why not?

At what price would the project’s fixed assets have to be sold (before tax) to change your decision?            

	Recovery Period Class
Year	3-Year	5-Year	7-Year	10-Year	15-Year	20-Year
1	33.33%	20%	14.29%	10%	5%	3.75%
2	44.45%	32%	24.49%	18%	9.50%	7.22%
3	14.81%	19.20%	17.49%	14.40%	8.55%	6.68%
4	7.41%	11.52%	12.49%	11.52%	7.70%	6.18%
5		11.52%	8.93%	9.22%	6.93%	5.71%
6		5.76%	8.93%	7.37%	6.23%	5.28%
7			8.93%	6.55%	5.90%	4.89%
8			4.45%	6.55%	5.90%	4.52%
9				6.55%	5.90%	4.46%
10				6.55%	5.90%	4.46%
11				3.29%	5.90%	4.46%
12					5.90%	4.46%
13					5.90%	4.46%
14					5.90%	4.46%
15					5.90%	4.46%
16					2.99%	4.46%
17						4.46%
18						4.46%
19						4.46%
20						4.46%
21						2.25%

Answer 1

Revenues	1	2	3	4	5
New sales volume	10000	15000	25000	20000	5000
Sales price	$75	$75	$75	$75	$75
New sales revenue	$7,50,000	$11,25,000	$18,75,000	$15,00,000	$3,75,000
Lost sales volume	3000	3000	3000	3000	3000
Lost sales price	$45	$45	$45	$45	$45
Lost sales revenue	$1,35,000	$1,35,000	$1,35,000	$1,35,000	$1,35,000
Existing price impact	$25,000	$25,000	$25,000	$25,000	$25,000
Total lost revenues	$1,60,000	$1,60,000	$1,60,000	$1,60,000	$1,60,000
Net sales revenue	$5,90,000	$9,65,000	$17,15,000	$13,40,000	$2,15,000
Costs
Unit variable cost	$35	$35	$35	$35	$35
Total variable costs	$3,50,000	$5,25,000	$8,75,000	$7,00,000	$1,75,000
Avoided variable costs	$45,000	$45,000	$45,000	$45,000	$45,000
Net variable costs	$3,05,000	$4,80,000	$8,30,000	$6,55,000	$1,30,000
Income Statement	1	2	3	4	5
Sales revenue	$5,90,000	$9,65,000	$17,15,000	$13,40,000	$2,15,000
Variable costs	$3,05,000	$4,80,000	$8,30,000	$6,55,000	$1,30,000
Fixed costs	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000
Depreciation	$4,99,950	$6,66,750	$2,22,150	$1,11,150
EBIT	-$3,64,950	-$3,31,750	$5,12,850	$4,23,850	-$65,000
Taxes	-$1,45,980	-$1,32,700	$2,05,140	$1,69,540	-$26,000
Net income	-$2,18,970	-$1,99,050	$3,07,710	$2,54,310	-$39,000
Cash flows	0	1	2	3	4	5
Operating cash flow		$2,80,980	$4,67,700	$5,29,860	$3,65,460	-$39,000
Net working capital	-$2,00,000					$2,00,000
Capital expenditures	-$15,00,000
Net salvage value						$1,80,000
Cash flows from assets	-$17,00,000	$2,80,980	$4,67,700	$5,29,860	$3,65,460	$3,41,000
Cost f capital	$1	$0.909	$0.826	$0.751	$0.683	$0.621
Present value of cash flows	-$17,00,000	$2,55,436	$3,86,529	$3,98,092	$2,49,614	$2,11,734
NPV	-$1,98,595

Since the NPV is negative, the project is not recommended.

If the fixed assets are sold above 835000, the NPV will become positive and hence the decison will be changed.