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Question
Chapter 8 Case
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Englewood Company has an opportunity to produce and sell a revolutionary new smoke detector for homes. To determine whether this would be a profitable venture, the company has gathered the following data on probable costs and market potential:
New equipment would have to be acquired to produce the smoke detector. The equipment would cost $100,000 and be useable for 12 years. After 12 years, it would have a salvage value equal to 10% of the original cost.
Production and sales of the smoke detector would require a working capital investment of $40,000 to finance accounts receivable, inventories, and day-to-day cash needs. This working capital would be released for use elsewhere after 12 years.
An extensive marketing study projects sales in units over the next 12 years as follows:
Year Sales in Units
1……………. 4,000
2……………. 7,000
3……………. 10,000
4-12………… 12,000
The smoke detectors would sell for $45 each; variable costs for production, administration, and sales would be $25 per unit.
To gain entry into the market, the company would have to advertise heavily in the early years of sales. The advertising program follows:
Amount of Yearly
Year Advertising
1-2…………. $70,000
3…………… $50,000
4-12……….. $40,000
Other fixed costs for salaries, insurance, maintenance, and straight-line depreciation on equipment would total $127,500 per year. (Depreciation is based on cost less salvage value.)
The company’s required rate of return is 20%
Required:
(6 points) Compute the net cash inflow (cash receipts less yearly cash operating expenses) anticipated from the sale of the smoke detectors for each year over the next 12 years.
(4 points) Using the data computed in (1) above and other data provided in the problem, determine the net present value of the proposed investment. Would you recommend that Englewood Company accept the smoke detector as a new product?
Explanation / Answer
Part 1 Year 1 2 3 4-12 Sales in units 4,000 7,000 10,000 12,000 Sales in dollars (@ $45 each) $ 180,000 $ 315,000 $ 450,000 $ 540,000 Variable expenses (@ $25 each) 100,000 175,000 250,000 300,000 Contribution margin 80,000 140,000 200,000 240,000 Fixed expenses: Salaries and other* 120,000 120,000 120,000 120,000 Advertising 70,000 70,000 50,000 40,000 Total fixed expenses 190,000 190,000 170,000 160,000 Net cash inflow (outflow) $ (110,000) $ (50,000) $ 30,000 $ 80,000 * Depreciation is not a cash expense and therefore must be eliminated from this computation. The analysis is: ($100,000 – $10,000 = $90,000) ÷ 12 years = $7,500 depreciation; $127,500 total expense – $7,500 depreciation = $120,000. Part 2 The net present value of the proposed investment would be: Item Year(s) Amount of Cash Flows 20% Factor Present value of cash flows Investment in equipment Now $ (100,000) 1.000 (100,000) Working capital needed Now $ (40,000) 1.000 (40,000) Yearly cash flows (see above) 1 $ (110,000) 0.833 (91,667) Yearly cash flows (see above) 2 $ (50,000) 0.694 (34,722) Yearly cash flows (see above) 3 $ 30,000 0.579 17,361 Yearly cash flows (see above) 4-12 $ 80,000 2.333* 186,619 Salvage value of equipment 12 $ 10,000 0.112 1,122 Release of working capital 12 $ 40,000 0.112 4,486 Net present value (56,801) * Present value factor for 12 periods 4.439 Present value factor for 3 periods 2.106 Present value factor for 9 periods, starting 4 periods in the future 2.333 Since the net present value is negative, the company should not accept the device as a new product.