Question

DecaSport is producing high technique and specialised sport shoes. The company has been conducting research and development of a new model, where the lower mould can automatically adjust itself to avoid foot injury. The model has been tested and the managing board is happy to launch its production if it's financial viable. The company already spent $800,000 for research and development. The new model will have a five-year lifetime, after that the company will stop its production. The new production machines will need to be bought and are budgeted at $7.5 million but can be used for another 5 years after the production of the new product is finished. The company depreciates fixed assets on a straight line basis to zero. The company expects to sell 80,000 pairs in the first year at $300 per pair. As the new technique can be potentially followed by competitors, every year the sale quantity is expected to decrease by 10% and the sale price will decrease by 8%. Gross profit on the product is targeted at 60% of sales. While the new model generates a high gross profit rate, the company expects a high level of product returns of 5% on sales. Marketing is one of the major parts of launching this new model. The company decides that the marketing cost of $1.2 million will be allocated annually based on annual units of sales. As a financial manager of the company, you’re conducting a capital budgeting analysis of the financial viability of the new model. The company shareholders expect a return on investment of 25% pa. The company pays tax at the rate of 30% on profits. Requirements: a. Use an Excel spreadsheet to calculate the following criteria, and then consider whether the new model will maximise wealth for the shareholders: 1. After-tax cash flows (7 marks). 2. Net present value (4 marks). 3. Payback period (4 marks). 4. Profitability index (3 marks). 5. Is it a viable project? Explain your answer (2 marks).

Answer 1

Given Variables =

Research Cost = 800000 ( This is Sunk Cost so not taken for Capital Budgeting)

Initial Investment = 7.5 Million

Sales Unit (1 year) = 80000 then decrease by 10% each Year

Sales Price (1 Year) = 300 then decrease by 10% Each year

GP Ratio = 60%

Fixed Cost = 1.2 Million divided based Units of Sales

Return on Investment = 25%

Tax Rate = 30%

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Total
Initial Investment	-75,00,000.00						-75,00,000.00
Sales Units		80,000.00	72,000.00	64,800.00	58,320.00	52,488.00	3,27,608.00
Sales Price		300.00	270.00	243.00	218.70	196.83	1,228.53
Total Revenue		2,40,00,000.00	1,94,40,000.00	1,57,46,400.00	1,27,54,584.00	1,03,31,213.04	8,22,72,197.04
GP Ratio (60%)		1,44,00,000.00	1,16,64,000.00	94,47,840.00	76,52,750.40	61,98,727.82	4,93,63,318.22
Fixed Cost		2,93,033.14	2,63,729.82	2,37,356.84	2,13,621.16	1,92,259.04	12,00,000.00
EBIT		1,41,06,966.86	1,14,00,270.18	92,10,483.16	74,39,129.24	60,06,468.78	4,81,63,318.22
Tax (30%)		42,32,090.06	34,20,081.05	27,63,144.95	22,31,738.77	18,01,940.63	1,44,48,995.47
Earning after Tax		98,74,876.80	79,80,189.12	64,47,338.21	52,07,390.47	42,04,528.15	3,37,14,322.76
Total (Outflow)/Inflow	-75,00,000.00	98,74,876.80	79,80,189.12	64,47,338.21	52,07,390.47	42,04,528.15
PV @ 25%	1.00	0.80	0.64	0.51	0.41	0.33
Discounted Cash Flow	-75,00,000.00	78,99,901.44	51,07,321.04	33,01,037.16	21,32,947.14	13,77,739.78	1,23,18,946.57
Payback Period	0.95
Profitability Index	2.64

This Project is Viable as it is giving Positive NPV to the organisation.