Question

CASE STUDY 1 - Matheson Electronics (NPV, IRR) Matheson Electronics has just developed a new electronic device which, when mounted on an automobile, will tell the driver how many miles the automobiles traveling per gallon of gasoline The company is nous to begin production of the new device. To this end, marketing and cost studies have been made to determine probable costs and market potential. These studies have provided the following information: New equipment would have to be acquired to produce the device. The equipment would cost $315.000 and have 12-year useful life. After 12 years, it would have a salvage value of about $15.000 Sales in units over the next 12 years are projected to be as follows: Year Sales in unit Production and sales of the device would require working capital of $60,000 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 The device would sell for $36 each; variable costs of production, administration, and sales would be $15 per unit. Fixed costs for salaries, maintenance, property taxes, insurance, and straight line depreciation on the equipment would total $135,000 per year. To gain rapid entry into the market, the company would have to advertise heavily. The advertising program would be Amount of Yearly Advertising $180.000 310000 5120100 Matheson Electronics' board of directors has specified a required rate of return of 14% on all new products Requirements: You will be required to write a management report to the management of Matheson Electronics in which the following points should be discussed. Analyze the Investment proposals by using NPV and provide recommendations. You should also briefly comment on other investment proposal techniques that Matheson Electronics may use, and the limitations of using those techniques. • Provide an explanation on the different sources of funding available to the company, and their advantages and disadvantages and make recommendations as to how these funding sources are appropriate to the planned investment and expansion program. • The use of management tools such as Breakeven analysis and Budgets. • A computation of your breakeven analysis and the cash budget for December 2019 and January 2020.

Answer 1

Calculation of Contribution margin per unit

Selling Price	36
Variable cost	(15)
Contribution Margin per unit	21

Calculation of Net Present Value

Sales Units		6,000	12,000	15,000	18,000
Particulars	0	1	2	3	4-12
Purchase of new equipment	(315,000)				15,000
Requirement of working capital	(60,000)				60,000
Total contribution from sale of units		126,000	252,000	315,000	378,000	Total Units sold X Contribution
Fixed Cost		(107,500)	(107,500)	(107,500)	(107,500)	135000 - depreciation of equipment
Advertisement cost		(180,000)	(180,000)	(150,000)	(120,000)
Net Cash flows	(375,000)	(161,500)	(35,500)	57,500	225,500
Present Value Factor @14%	1	0.8772	0.7695	0.6750	3.6805
Total Discounted CashFlows	(375,000)	(141,668)	(27,317)	38,813	829,953
Net Present Value	324,780					Addition of all the discounted cashflows

Calculation of depreciation of equipment = (315000-15000) / 12 = 27500 per year

Note- As depreciation is not the cash cost it is not to be considered while evaluating the project hence deducted from the fixed cost of 135000.

Overall NPV is positive hence the project can be accepted. The cashflows are negative for year 1 and 2 hence funds have to be managed for first 2 years. Company has to arrange funds from outside if not owned then in such case cost of those funds has to be incorporated in above calculation and then the NPV should be evaluated again. For the above project advertisement cost and other fixed cost are very high and it may be main concern of the management. Management may thing various ways to reduce this cost to improve the net profit.

Additional funds can be taken by the company from outside borrowings but then it will have some interest cost which may reduce the NPV of the project. Company may think to manage the period of loss years by inhouse funding which is the best possible way to introduce the new product in the market.

Breakeven analysis -

Formula - Fixed cost / Contribution margin per unit

Fixed cost = 107500 X 12 = 1,290,000 + (advertisement cost) 180000+180000+150000+120000 X 9 = 1,590,000

Total = 2,800,000

= 2,800,000 / 21

= 1,37,143 units.

The Break even point suggest after selling 137,143 units in the market then company may think of recovering profit.

Note - there is no information provided for cash budget for Dec 2019 and Jan 2020 hence it cannot be prepared.