Question

help me solve this?

EMU ELECTRONICS Emu Electronics is an electronics manufacturer located in Box Hill, Victoria. The company’s managing director is Shelly Chan, who inherited the company from her father. The company originally repaired radios and other household appliances when it was founded more than 50 years ago. Over the years, the company has expanded, and it is now a reputable manufacturer of various specialty electronic items. Robert McCanless, a recent graduate, has been hired by the company in the finance department. One of the major revenue-producing items manufactured by Emu Electronics is a smart phone. Emu Electronics currently has one smart phone model on the market and sales have been excellent. The smart phone is a unique item in that it comes in a variety of colours and is pre-programmed to play Jimmy Barnes’s music. However, as with any electronic item, technology changes rapidly, and the current smart phone has limited features in comparison with newer models. Emu Electronics has spent £750 000 developing a prototype for a new smart phone that has all the features of the existing one, but adds new features, such as Wifi Tethering. The company has spent a further £200 000 for a marketing study to determine the expected sales figures for the new smart phone. Emu Electronics’ production manager has produced estimates of the costs associated with manufacture of the new smart phone. Variable costs are estimated at £205 per unit and fixed costs for the operation are expected to run at £5.1 million per year. The estimated sales volume is 64 000 units in Year 1; 106 000 units in Year 2; 87 000 units in Year 3; 78 000 units in Year 4; and 54 000 units in the final year. The unit price of the new smart phone will be £485. The necessary manufacturing equipment can be purchased for £34.5 million and will be depreciated for tax purposes over a seven-year life (straight-line to zero). It is believed the value of the manufacturing equipment in five years’ time will be £5.5 million. Net working capital for the smart phones will be 20% of sales and will have to be purchased at the end of the year. The cost of the raw materials is reflected in the variable unit cost. Changes in NWC will first occur at the end of Year 1 based on the first year’s sales. Emu Electronics has a 30% corporate tax rate and a 12% required return. Required: Shelly has asked Robert to prepare a report that answers the following questions: How sensitive is the NPV to changes in the quantity sold?

Answer 1

STEP:1 Computation of present value of cash outflows:

Manufacturing equipment cost = £ 34,500,000

For decision making we are not considering the cost already incurred (i.e.Emu Electronics has spent £750 000 developing a prototype for a new smart phone that has all the features of the existing one & further £200 000 for a marketing study to determine the expected sales figures for the new smart phone)

STEP:2 Computation of present value of cash inflows:

Depreciation = (cost of the asset - salvage value) / life of the asset

= (£ 34,500,000 - £ 5,500,000) / 5 years.

= £ 5,800,000 per year.

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Number of units	64,000.00	106,000.00	87,000.00	78,000.00	54,000.00
Sale price per unit	£                485.00	£                485.00	£                485.00	£                485.00	£                485.00
Total revenne	£ 31,040,000.00	£ 51,410,000.00	£ 42,195,000.00	£ 37,830,000.00	£ 26,190,000.00
Variable cost per unit	£                205.00	£                205.00	£                205.00	£                205.00	£                205.00
Total variable cost	£ 13,120,000.00	£ 21,730,000.00	£ 17,835,000.00	£ 15,990,000.00	£ 11,070,000.00
Net working capital		£    6,208,000.00	£ 10,282,000.00	£    8,439,000.00	£    7,566,000.00	£ 5,238,000.00
Depreciation	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00
Gross profit /loss	£ 12,120,000.00	£ 17,672,000.00	£    8,278,000.00	£    7,601,000.00	£    1,754,000.00	-£ 5,238,000.00
Tax @ 30%	£    3,636,000.00	£    5,301,600.00	£    2,483,400.00	£    2,280,300.00	£        526,200.00	-£ 1,571,400.00
Net profit after tax	£    8,484,000.00	£ 12,370,400.00	£    5,794,600.00	£    5,320,700.00	£    1,227,800.00	-£ 3,666,600.00
Add: Depreciation	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00
Net cash flows	£ 14,284,000.00	£ 18,170,400.00	£ 11,594,600.00	£ 11,120,700.00	£    7,027,800.00	-£ 3,666,600.00
PV factor @ 12%	0.893	0.797	0.712	0.636	0.567	0.507
Present value	£ 12,753,571.43	£ 14,485,331.63	£ 8,252,807.26	£   7,067,405.89	£      3,987,762.46	£ (1,857,613.67)

Present value of cash inflows = £44,689,265

Present value of salvage value = £5,500,000 X 0.567 = £ 3,120,847.71

Total present value of cash inflows = £44,689,265 + £ 3,120,847.71 = £ 47,810,112.71.

Net present value = Present value of cash inflows - present value of cash outflows

= £ 47,810,112.71 - £ 34,500,000

NPV = 13,310,112.71.

conclusion: It's better to purchase a new machinery and proceed further.

Sensitivity of NPV is to changes in quantity is 2.886% (i.e if the quantity increases by 1% in each year than my NPV will increases by 2.9%. , below is the workings for the same,

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Number of units	64,000.00	106,000.00	87,000.00	78,000.00	54,000.00
Increase in number of units	1%	1%	1%	1%	1%
Total number of units	64,640.00	107,060.00	87,870.00	78,780.00	54,540.00
Sale price per unit	£                485.00	£                485.00	£                485.00	£                485.00	£                485.00
Total revenne	£ 31,350,400.00	£ 51,924,100.00	£ 42,616,950.00	£ 38,208,300.00	£ 26,451,900.00
Variable cost per unit	£                205.00	£                205.00	£                205.00	£                205.00	£                205.00
Total variable cost	£ 13,251,200.00	£ 21,947,300.00	£ 18,013,350.00	£ 16,149,900.00	£ 11,180,700.00
Net working capital		£    6,270,080.00	£ 10,384,820.00	£    8,523,390.00	£    7,641,660.00	£ 5,290,380.00
Depreciation	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00
Gross profit /loss	£ 12,299,200.00	£ 17,906,720.00	£    8,418,780.00	£    7,735,010.00	£    1,829,540.00	-£ 5,290,380.00
Tax @ 30%	£    3,689,760.00	£    5,372,016.00	£    2,525,634.00	£    2,320,503.00	£        548,862.00	-£ 1,587,114.00
Net profit after tax	£    8,609,440.00	£ 12,534,704.00	£    5,893,146.00	£    5,414,507.00	£    1,280,678.00	-£ 3,703,266.00
Add: Depreciation	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00	£    5,800,000.00
Net cash flows	£ 14,409,440.00	£ 18,334,704.00	£ 11,693,146.00	£ 11,214,507.00	£    7,080,678.00	-£ 3,703,266.00
PV factor @ 12%	0.893	0.797	0.712	0.636	0.567	0.507
Present value	£ 12,865,571.43	£ 14,616,313.78	£ 8,322,950.36	£ 7,127,021.94	£ 4,017,766.85	£ (1,876,189.81)

NPV= £45,073,434.55+£ 3,120,847.71- £34,500,000 =£13,694,282.26

% of NPV change = (New NPV-Old NPV)/ Old NPV

= (13,694,282.26-13,310,112.71) /13,310,112.71

= 2.886%