Question

Matheson Electronics has just developed a new electronic device that it believes will have broad market appeal. The company has performed marketing and cost studies that revealed the following information:

1. New equipment would have to be acquired to produce the device. The equipment would cost $138,000 and have a six-year useful life. After six years, it would have a salvage value of about $24,000.
2. Sales in units over the next six years are projected to be as follows:

Year	Sales in Units
1	7,000
2	12,000
3	14,000
4–6	16,000

3. Production and sales of the device would require working capital of $46,000 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.
4. The devices would sell for $55 each; variable costs for production, administration, and sales would be $35 per unit.
5. Fixed costs for salaries, maintenance, property taxes, insurance, and straight-line depreciation on the equipment would total $149,000 per year. (Depreciation is based on cost less salvage value.)
6. To gain rapid entry into the market, the company would have to advertise heavily. The advertising costs would be:

Year	Amount of Yearly Advertising
1–2	$	75,000
3	$	55,000
4–6	$	45,000

7. The company’s required rate of return is 13%.

Required:

1. Compute the net cash inflow (incremental contribution margin minus incremental fixed expenses) anticipated from sale of the device for each year over the next six years.

2-a. Using the data computed in (1) above and other data provided in the problem, determine the net present value of the proposed investment.

2-b. Would you recommend that Matheson accept the device as a new product?

Answer 1

1.

Compute the net cash inflow anticipated from sale of the device for each year as follows:

	Year	1	2	3	4	5	6
a	Incremental sales in units	7000	12000	14000	16000	16000	16000
b	Selling price	55	55	55	55	55	55
c = a x b	Incremental sales revenue	385000	660000	770000	880000	880000	880000
d = a x 35	Incremental variable costs	245000	420000	490000	560000	560000	560000
e = c - d	Incremental contribution margin	140000	240000	280000	320000	320000	320000
f	Incremental fixed costs	149000	149000	149000	149000	149000	149000
g	Advertising costs	75000	75000	55000	45000	45000	45000
h = e - f - g	Operating income	-84000	16000	76000	126000	126000	126000
i	Depreciation	19000	19000	19000	19000	19000	19000
j = h + i	Net cash inflow from sale of device	-65000	35000	95000	145000	145000	145000
Depreciation = [Cost - Salvage value]/Useful life = ($138,000 - $24,000)/6 = $19,000

2-a.

Compute the net present value of the proposed investment as follows:

Year	0	1	2	3	4	5	6
Cost of equipment	-138000
Working capital employed	-46000
Net cash flow from sale of device		-65000	35000	95000	145000	145000	145000
Salvage value							24000
Release of working capital							46000
Net cash flows	-184000	-65000	35000	95000	145000	145000	215000
Discount factor @ 13%	1.000	0.885	0.783	0.693	0.613	0.543	0.480
Present value	-184000	-57525	27405	65835	88885	78735	103200
Net present value	122535

2-b.

Yes, Matheson accept the device as a new product because the net present value of the proposed investment is positive.