Question

You must analyze a potential new product --- a caulking compound that Korry Materials’ R&D people developed for use in the residential construction industry. Korry’s marketing manager thinks they can sell 115,000 tubes per year at a price of $3.25 each for 3 years, after which the product will be obsolete. The required equipment would cost $125,000, plus another $25,000 for shipping and installation. Current assets (receivables and inventories) would increase by $35,000, while current liabilities (accounts payables and accruals) would rise by $15,000. Variable costs would be 60 percent of sales revenue, fixed costs (exclusive of depreciation) would be $70,000 per year, and the fixed assets would be depreciated under MACRS with a 3-year life. When production ceases after 3 years, the equipment should have a market value of $15,000. Korry’s tax rate is 40 percent, and it uses a 10 percent WACC for average risk projects.

The R&D costs for the new product were $30,000, and those costs were incurred and expensed for tax purposes last year. If Korry Materials accepts the new project it will result in an annual loss of revenues on an existing product of $5,000.

Find the required year 0 investment, the annual after-tax operating cash flows, and the terminal year cash flow. Assuming the project is of average risk, would you recommend accepting the project. Justify your answer.

Answer 1

ANSWER:-

	YEAR 0 INVESTMENT:
	Cost of equipment	125000
	Shipping and installation	25000
	Installed cost of equipment	150000
	Add: Increase in NWC [35000-15000]	20000
	Year 0 investment	170000
	ANNUAL AFTER TAX CASH FLOW:	0	1	2	3
	Sales revenue (115000*3.25)		373750	373750	373750
	Variable costs (60% of sales revenue)		224250	224250	224250
	Fixed costs other than depreciation		70000	70000	70000
	Depreciation		49995	66675	22215
	Loss of revenue on existing product		5000	5000	5000
	Incremental NOI		24505	7825	52285
	Tax at 40%		9802	3130	20914
	NOPAT		14703	4695	31371
	Add: Depreciation		49995	66675	22215
	ANNUAL AFTER TAX CASH FLOW:		64698	71370	53586
	Capital expenditure (125000+25000)	150000
	Increase in NWC (35000-15000)	20000			-20000
	After tax salvage value [15000-(15000-11115)*40%]				13446
	FCF	-170000	64698	71370	87032
	PVIF at 10% [PVIF = 1/1.1^n]	1	0.90909	0.82645	0.75131
	PV at 10%	-170000	58816	58983	65388
	NPV	13188
	DECISION:
	As the NPV is positive, the investment in the project is recommended.
	TERMINAL NON OPERATING CASH FLOWS:
	Release of NWC				20000
	After tax salvage value [15000-(15000-11115)*40%]				13446
	Terminal non operating cash inflow				33446