The Alpha Dog Company manufactures and distributes a variety of pet-related prod
ID: 2759560 • Letter: T
Question
The Alpha Dog Company manufactures and distributes a variety of pet-related products. In response to customer feedback relating to the fragile nature of many commercially available dog leashes, the company’s product development team has recently introduced a prototype of a new, virtually indestructible dog leash. The development of the prototype cost $250,000 in research and development costs. The product development team has presented their proposal to Adam Smith, the company’s president and CEO.
Adam has asked you, as the chief financial officer, to prepare an analysis of the proposal and to provide a decision regarding whether or not to pursue to proposal.
Your first step in the analysis was to commission a market survey to assess the potential demand for the new product. You hired a consulting firm, Williams and Connelly, at a flat rate of $100,000 to conduct this market research. The results of their study indicate that potential consumers would be willing to pay upwards of $75 per dog leash, on the presumption that it truly is indestructible. It is further estimated that Alpha will have this segment of the market virtually all to itself for 5 years, at which time it is believed the market will have become saturated and that sales of the new leash will cease. The market study indicates that unit sales volume for this period will as follows;
Year
Unit Sales
1
10,000
2
15,000
3
25,000
4
20,000
5
5,000
After assessing the market demand potential, your turn to the head of your manufacturing department, John Williams, to consider the operating costs of producing the new dog leash. John believes that it will be necessary to purchase some new manufacturing equipment for the new product. After calling several potential suppliers, John thinks that the best deal on the necessary equipment will cost Alpha $1.5 million. For tax purposes, this equipment will be classified under the 7-years MACRS classification. John also estimated that the variable costs of production, such as raw materials and labor, will cost about $35 per unit and that the fixed costs of production will run another $150,000 per year. Finally, John thinks that a reasonable estimate of the resale value of the production equipment will be about $300,000 5 years from now.
Next, you consult with Alpha’s marketing department to evaluate any potential impact on existing leash models. Janet Mellon, the head of the market department, thinks that the introduction of this new and improved product will take some sales away from its current top-of-the-line dog leash. If Alpha does not go ahead with the new product introduction, it is believed that its existing dog leash will sell for $45 per leash and that unit sales volume will be 8,000 units per year for the next 5 years. The production costs of the existing model have been established as $15 per unit in variable costs and fixed production costs of $200,000 per year. If Alpha were to go ahead with the new leash project, is has been estimated that unit sales of its existing product will decline to 5,000 units per year for the next 5 years. Additionally, Janet thinks that, in order to reach this sales volume, it will be necessary to reduce the selling price of the existing leash by $5 per unit.
Finally, based on Alpha’s past experience with new product introductions, you estimate that, at inception of the project, Alpha will need to invest $400,000 in inventory to support the anticipated sales volume. Of this amount, $200,000 will be financed by taking on additional short-term liabilities (i.e. buying inventory on credit). It is assumed that this working capital investment will be fully recovered at the end of the project’s 5-year horizon. Alpha pays income taxes at a marginal rate of 40% and assigns a required return of 10% to new product proposals.
Adam has asked you to prepare a formal report addressing the following points.
1. Prepare a forecast of the free cash flow (cash flow from assets) for the 5 year project, based on the information you’ve collected, being sure to account for the initial outlay(s) at time zero (today). (Assume that all cash flows occur at the end of the corresponding year.)
2. Calculate the payback and discounted payback periods for the dog leash project.
3. Calculate the Internal Rate of Return for the dog leash project.
4. Calculate the Net Present Value for the dog leash project.
5. Make a recommendation to Adam on the pursuit of the new endeavor. Justify your recommendation.
6. What sales price for the dog leash would change your decision? (Holding all else constant.)
7. All else equal, at what price (gross) for the fixed assets at the end of the project’s life would change your decision? (Assume the originally projected sales price for the leash.)
Year
Unit Sales
1
10,000
2
15,000
3
25,000
4
20,000
5
5,000
Explanation / Answer
Answer 1 & 4 Year (a)Sales Units (b)Profit before fixed Cost (c) = a*b (d)Fixed Cost (e)Loss in Contribution(WN 3) (f)Interest (g)Net Profit before tax(c-d-e-f) (h)Net Profit after tax (1-0.4) 0.6 (i)New Machine setup (j)MARCS Dep Rates (k)Depreciation (l)Tax Shield on Depreciation(k*0.4) (m)Net Cash inflow(h+i+l) (n)Present Value factor (0)Net Present Value(m*n) 0 - 1,500,000 - 1,500,000 1.00 - 1,500,000 1 10,000 40 400,000 150,000 115,000 4,000 131,000 78,600 14.29 214,350 85,740 164,340 0.91 149,400 2 15,000 40 600,000 150,000 115,000 4,000 331,000 198,600 24.49 367,350 146,940 345,540 0.83 285,570 3 25,000 40 1,000,000 150,000 115,000 4,000 731,000 438,600 17.49 262,350 104,940 543,540 0.75 408,370 4 20,000 40 800,000 150,000 115,000 4,000 531,000 318,600 12.49 187,350 74,940 393,540 0.68 268,793 5 5,000 40 200,000 150,000 115,000 4,000 - 69,000 - 41,400 300,000 8.93 133,950 53,580 312,180 0.62 193,839 - 194,028 As NPV of the proposed plan is negative, project should not be accepted Working Notes: 1 As R&D cost for developing prototype and Market analysis have already been occured so this cost became IRRELAVENT for the decision making and has to be ignored. 2 Net Annual Cash flow potential consumers would be willing to pay upwards of $75 per dog leash. Upwards in price 75 Less Operating Cost 35 Profit before fixed Cost 40 3 Opportunity Loss Janet Mellon, the head of the market department, thinks that the introduction of this new and improved product will take some sales away from its current top-of-the-line dog leash. Loss of Sale of current product 3000 units Less: Contribution (45-15) 30 Opportunity loss 90000 Add: Additional contribution loss to sustain sale of 5000units 25000 Total 115000 4 Interest Short term liability 200000 10% Interest 20000 Interest every year 4000 Answer 2 & 3 Year Net Cash inflow Payback Present Value of Net Cashflow Payback Discounted 0 - 1,500,000 - 1,500,000 1 164,340 164,340 149,400 149,400 2 345,540 509,880 285,570 434,970 3 543,540 1,053,420 408,370 843,340 4 393,540 1,446,960 268,793 1,112,133 5 312,180 1,759,140 193,839 1,305,972 Payback period = between 4 and 5 years = 1500000-1446960 312180 = 0.169 i.e. 2 months Payback period= 4 yrs and 2 months Discounted payback period is above 5 yrs.
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