A manufacturing firm is considering the production of a new electronic device. T

Question

A manufacturing firm is considering the production of a new electronic device. This project has an estimated life of 7 years and requires an initial capital outlay of $5.2 million. The salvage value is negligible. The fixed production costs will amount to $1 million per year. However, the demand and the unit variable production costs (assumed constant within the plant's range of operating capacities) for such a new device are uncertain. A market survey and a detailed cost analyses have yielded the following information concerning these parameters (highest probability is most probable): The firm's cost of capital is 15% (i) and the selling price of the new device is $100 per unit. Assume that annual demand and unit variable production costs are independent. Please ignore income taxes. Determine the expected value (EV) for total annual operating costs. [$3,473,500] Determine the most-likely net present value. [$1,040,600]

Explanation / Answer

Capital investment will mean long term Investment. Here firm is going to invest in a new capital project of 7 years duration. Initially a large sum of money is invested. It is $5.2 million. Decision will be based on Net present value. It is calculated in the following manner.

Step 1; First calculate expected sales volume. It is added value of demand and expected value.

Step2: Sale price per unit is $100. It is multiplied with expected sales volume to get total expected sales.

Step3: Estimate expected variable cost per unit. It is the sum of different variale costs muliplied by probability.

Step5. Multiply expected variable cost and quantity sold to get expected total variable cost.

Step6: Add fixed operating cost of one million dollar to get expected value of total operating cost.

Step 7: Deduct it from expected total sale to get Expected operating profit.

Step 8: Ascertain present value of $1 receivable after years. Discouting rate is 15%.

Step 9: Multiply discount factor and net cash flow and add them to get gross expected present value.

Step 10: Finally deduct initial outlay from figure of step 9 to get expected net present valuer.

Calculations are shown below:

Answer:

1. Expected value of operating cost =$3,473,500

2. Most likely NPV = $1,566,922.70. It is not tallying with the answer given. But if data of the problems are correct, then it should be the correct answer.

Statement showing calculation of most likely NPV Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Total 1. Estimated life 7 years 2. Initial capital outlay -$5,200,000.00 3. Salvage value $0.00 4. Expected demand:      =40,000*0.2=8,000      =50,000*0.5=25,000     = 60,000*0.3=18,000        Total           =51,000 $51,000.00 $51,000.00 $51,000.00 $51,000.00 $51,000.00 $51,000.00 $51,000.00 $357,000.00 5.. Sale price per unit $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 6. Total sales [4*5] $5,100,000.00 $5,100,000.00 $5,100,000.00 $5,100,000.00 $5,100,000.00 $5,100,000.00 $5,100,000.00 $35,700,000.00 7. Expected variable production cost:      =40*0.1=4      =45*0.2=9      =50*.6=30      =55*0.1=5.5        Total=48.5 $48.50 $48.50 $48.50 $48.50 $48.50 $48.50 $48.50 8. Total variale production cost[4*7] $2,473,500.00 $2,473,500.00 $2,473,500.00 $2,473,500.00 $2,473,500.00 $2,473,500.00 $2,473,500.00 $17,314,500.00 9. Total fixed production cost $1,000,000.00 $1,000,000.00 $1,000,000.00 $1,000,000.00 $1,000,000.00 $1,000,000.00 $1,000,000.00 $7,000,000.00 10. Expected value of net operating cost [8+9] $3,473,500.00 $3,473,500.00 $3,473,500.00 $3,473,500.00 $3,473,500.00 $3,473,500.00 $3,473,500.00 $24,314,500.00 11. Net expected cash flow [6-10] $1,626,500.00 $1,626,500.00 $1,626,500.00 $1,626,500.00 $1,626,500.00 $1,626,500.00 $1,626,500.00 $31,314,500.00 11. Discounted present value at 15% 0.869565217 0.756143667 0.657516232 0.571753246 0.497176735 0.432327596 0.37593704 4 12. Present value of cash flow $1,414,347.83 $1,229,867.67 $1,069,450.15 $929,956.65 $808,657.96 $703,180.83 $611,461.60 $6,766,922.70 13. Less Initial cash outflow [point 2 above] -$5,200,000.00 14. Most likely NPV [12+13] $1,566,922.70

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