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.
a. Use an Excel spreadsheet to calculate the following criteria, and then consider whether the new model will maximise wealth for the shareholders:
- After-tax cash flows.
- Net present value.
- Payback period.
- Profitability index.
- Is it a viable project? Explain your answer.
b. Although the company is optimistic about the new model, the board wants to know at what level launching the new model becomes risky. Use an Excel spreadsheet and recalculate after-tax cash flows and net present value for the below scenarios:
(i) Sales units at 10% higher than estimated in the first year.
(ii) Sales units at 10% lower than estimated in the first year.
(iii) Comments on your findings.
(iv) You are required to use after-tax cash flows. Explain why this requirement is appropriate in decision making.
c. Regarding buying new production machines at $7.5m to produce the new product, you can pay all at once when the purchasing contract is signed and receive a 5% discount. You can also choose to pay monthly or quarterly. If you pay monthly, you will pay at the end of each month. The monthly payment is $260,000 in the first year and $410,000 in the second year. If you pay quarterly, you will pay at the end of the quarter and the quarterly payment is $670,000 in 3 years. Using a risk adjusted rate of 8% and an Excel spreadsheet, provide a fully worked analysis. Decide and explain which payment option should be undertaken.
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