Every two years a new product is developed by Company XYZ. In the past year $25,

Question

Every two years a new product is developed by Company XYZ. In the past year $25,000 was invested in the newest proposed product, Product B. The company hired a consultant for $10,000 who stated that the company should make Product B. New equipment will cost $5,000,000. This equipment will depreciate using 3 year MACRS.After 3 years Company XYZ will sell the equipment for $25,000. During the 3 years Product B is produced the company believes it will sell 150,000 of Product B for $50 each. For the first year Company XYZ produces Product B it expects sales for its current model, Product A, to decrease by $100,000. After that first year Product A will stop being produced. Operating costs for Product B will be 45% of sales. Tax rate is 40%. Required return is .09. Should Product B be produced?

Explanation / Answer

NPV of the project = 2755000/1.09 + 2795000/1.09^2 + 2820000/1.09^3 - 5035000

= 7057575.93-5035000

= $2,022,575.93

Hence, product B should be produced since the NPV of the investment is positive.

Year 1 Year 2 Year 3 Cost of setting up the production of Product B = (New equipment+ cost of the consultant+ investment the previous year 5035000 Revenues from product B = 150000 ( Expected units to be sold) * 50 ( cost per unit ) 7500000 7500000 7500000 Revenues lost because of product B 100000 Cost of goods sold = 40% * revenues 3000000 3000000 3000000 Depreciation 1658333 1658333 1658333 EBIT 2741667 2841667 2841667 Net profit @ 40% tax 1096667 1136667 1136667 Cash flow = Net profit + Depriciation 2755000 2795000 2795000 Cash flow from the sale of equipment in 3rd year = 25000 2755000 2795000 2820000

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