New Project Problem Med Drive, Inc. manufactures a line of traditional light-wei
ID: 2461772 • Letter: N
Question
New Project Problem
Med Drive, Inc. manufactures a line of traditional light-weight adjustable collapsing wheel chairs for medical transport. Management is considering a business proposal to produce a new line of hydraulic reclining wheel chairs. The proposal has been studied carefully and the following information is forecast: Cost of new production equipment and machinery including
freight and setup (Assume 5 year straight line depreciation to 0) $220,000
Expense of hiring and training new employees . . . 121,500
Pre-start-up advertising and other miscellaneous expenses 25,000
Additional selling and administrative expense per year after start-up 115,000
Unit sales forecast
Year 1 300
Year 2 700
Year 3 1,100
Year 4 and beyond 1,600
Unit Price 700
Unit cost to manufacture (60% of revenue) 420
Last year, anticipating an interest in hydraulic reclining wheelchairs, the company bought the rights to a new hydraulic mechanism design for $70,000.
Med Drive production facilities are currently being utilized to capacity, so a new shop has to be acquired for incremental production. The company owns a lot near the present facility on which a new building can be constructed for $195,000 (assume 39 year straight line depreciation). The land was purchased 10 years ago for $60,700, and now has an estimated market value of 120,000.
If Med Drive produces hydraulic reclining wheel chairs, it expects to lose some of its current sales to the new product. Three percent of the new unit forecast is expected to come out of sales that would have been made in the old line. Prices and direct costs are about the same in the old line as in the new.
Med Drive's general overhead includes personnel, finance, and executive functions, and runs about 5% of revenue. Small one-time increments in business don’t affect overhead spending, but a major continuing increase in volume would require additional support. Management estimates that additional spending in overhead areas will amount to about 2% of the new project’s revenues.
Accounts receivable at year-end are expected to be 1/12 of the average of the current and the next year ‘s sales. Incremental inventories are estimated at $12,000 at start-up and for the first year. After that an inventory turnover of 15 times based on cost of sales is expected. Incremental payables are estimated to be 25% of inventories.
Med Drive's current business is profitable, so losses in the new line will result in tax credits. The company’s marginal tax rate is 35%.
Med Drive Inc. expects to sell the new line at the end of the 6th year for the price equal to the perpetuity of that year’s OCF discounted by its cost of capital of 16.8% (proceeds taxed at 35%).
Based on this data estimate cash flows for each of the six years, the project’s IRR and NPV, and suggest whether to accept or reject the new business proposal.
This is a "real life" problem and, as such, does not necessarily have a “correct” answer. Your logic, knowledge of the subject is what matters.
Explanation / Answer
Calculation of cash flows
Year 1 Revenue from sales (300*700) = $210000
- Cost to manufacture (210000*60%) = $126000
- General overhead (210000*5%) = $10500
- Additional spending on overhead = $4200
(210000*2%)
Total Cash Flows $69300
Year 2 Revenue from sales (700*700) = $490000
- Cost to manufacture (490000*60%) = $294000
- General overhead (490000*5%) = $24500
- Additional spending on overhead = $9800
(490000*2%)
Total Cash Flows $161700
Year 3 Revenue from sales (1100*700) = $770000
- Cost to manufacture (770000*60%) = $462000
- General overhead (770000*5%) = $38500
- Additional spending on overhead = $15400
(770000*2%)
Total Cash Flows $254100
Year 4 Revenue from sales (1600*700) = $1120000
- Cost to manufacture (1120000*60%) = $672000
- General overhead (1120000*5%) = $56000
- Additional spending on overhead = $22400
(1120000*2%)
Total Cash Flows $369600
Year 5 would be same as year 4 $369600
Year 6 Cash flows = $369600 + sale proceeds of new product line-Tax
= $369600 + 369600* discounting factor@ 16.8% in year 6-Tax
=$369600 + 369600*0.394- (145622.4-35%)
=$420567.84
Cash outfolws at Year 0 = $481500 =(220000+121500+25000+115000)
Calculation of NPV of the project
IRR
The IRR would be around 20%
Year Cash Flows Discounting Factor PV of cash flows 0 $481500 1 ($481500) 1 $69300 0.856 $59320.8 2 $161700 0.733 $118526.1 3 $254100 0.627 $159320.7 4 $369600 0.537 $198475.2 5 $369600 0.46 $170016 6 $420567.84 0.394 $165703.729 NPV $389862.529