Amadeus Corporation is considering the issue of a new product to be added to its

Question

Amadeus Corporation is considering the issue of a new product to be added to its product mix. They hired you, a recent business graduate from MacEwan, for conducting the analysis. The production line would be set up in an unused space at the company's main plant. The plant space could be leased out to another firm for S25,000 per year. They have to buy new machinery. The approximate cost of the machine would be $200,000, with another $10,000 in shipping and handling charges. It would also cost an additional S30,000 to install the equipment. The machinery has an economic life of 5 years and would fall under Class 8 with a CCA rate of 20%-The machinery is expected to have a salvage value of $25,000 after 5 years of use The new product line would generate incremental sales of 1,250 units per year for 5 years and they are expected to grow 10% per year. The cost per unit is estimated in $75 per unit in the first year. Each unit can be sold for S200 in the first year. The sales price and cost are both expected to increase by 2.5% per year due to inflation. The fixed costs are estimated to be $100,000 per year and would increase with inflation. To handle the new product line, the firm's net operating working capital would have to increase by an amount equal to 15% of sales revenues. The firm tax rate is 35%, and its overall weighted average cost of capital (WACC) is 14%. The project is considered by the financial department to be as risky as the company

Explanation / Answer

0 1 2 3 4 5 Opportunity cost of lost lease rent -25000 -25000 -25000 -25000 -25000 a. Cost of new machinery,shipping,handling&installation -240000 b. Additional NWC reqd. in each year(See workings) -37500 -4781 -5391 -6078 -6853 c. Recovery of NWC(see workings) 60603 d. After-tax salvage 25000 e. Opp.cost,CAPEX& NWC -240000 -62500 -29781 -30391 -31078 53750 Operating cash flows : 1. Incremental sales in units 1250 1375 1513 1664 1830 2. Selling price/unit 200 205 210.13 215.38 220.76 3.Total sale value(1*2) 250000 281875 317814.1 358335.4 404023.1 4. Variable Cost per unit 75 76.88 78.80 80.77 82.79 5. Total variable cost (1*4) 93750 105703.13 119180.3 134375.8 151508.7 6.Fixed costs 100000 102500 105063 107689 110381 7. Depreciation (240000-25000)*CCA 20%) 43000 43000 43000 43000 43000 8.Pretax income(3-5-6-7) 13250 30672 50571 73271 99133 9. Tax at 35%(8*35%) 4638 10735 17700 25645 34697 10. After-tax income(8-9) 8613 19937 32871 47626 64437 11.Add Back Depn. 43000 43000 43000 43000 43000 12.Operating cash flow 51613 62937 75871 90626 107437 13.Net annual cash flows(e+12) -240000 -10888 33155 45480 59548 161187 14.PV F at 14% 1 0.87719 0.76947 0.67497 0.59208 0.51937 15. PV at 14%(13*14) -240000 -9550 25512 30698 35257 83715 NPV(Sum PVs at 15.) -74368 IRR 4% WORKINGS: Net Working capital reqd. each year 3.Total sale value(1*2) 250000 281875 317814 358335 404023 NWC reqd. 15%*sales 37500 42281 47672 53750 60603 Additional NWC reqd. in each year -37500 -4781 -5391 -6078 -6853 Recovery of NWC 60603 Cash breakeven   (By Trial & Error in the above table) Happens roughly at 1472 units of Year 1 sales 0 1 2 3 4 5 Opportunity cost of lost lease rent -25000 -25000 -25000 -25000 -25000 a. Cost of new machinery,shipping,handling&installation -240000 b. Additional NWC reqd. in each year(See workings) -44160 -5630.4 -6348 -7158 -8070 c. Recovery of NWC(see workings) 71367 d. After-tax salvage 25000 e. Opp.cost,CAPEX& NWC -240000 -69160 -30630 -31348 -32158 63296 Operating cash flows : 1. Incremental sales in units 1472 1619 1781 1959 2155 2. Selling price/unit 200 205 210.13 215.38 220.76 3.Total sale value(1*2) 294400 331936 374257.8 421975.7 475777.6 4. Variable Cost per unit 75 76.88 78.80 80.77 82.79 5. Total variable cost (1*4) 110400 124476 140346.7 158240.9 178416.6 6.Fixed costs 100000 102500 105063 107689 110381 7. Depreciation (240000-25000)*CCA 20%) 43000 43000 43000 43000 43000 8.Pretax income(3-5-6-7) 41000 61960 85849 113046 143980 9. Tax at 35%(8*35%) 14350 21686 30047 39566 50393 10. After-tax income(8-9) 26650 40274 55802 73480 93587 11.Add Back Depn. 43000 43000 43000 43000 43000 12.Operating cash flow 69650 83274 98802 116480 136587 13.Net annual cash flows(e+12) -240000 490 52644 67453 84322 199883 14.PV F at 14% 1 0.87719 0.76947 0.67497 0.59208 0.51937 15. PV at 14%(13*14) -240000 430 40508 45529 49925 103813 NPV(Sum PVs at 15.) 205 IRR 14% WORKINGS: Net Working capital reqd. each year 3.Total sale value(1*2) 294400 331936 374257.8 421975.7 475777.6 NWC reqd. 15%*sales 44160 49790 56139 63296 71367 Additional NWC reqd. in each year -44160 -5630 -6348 -7158 -8070 Recovery of NWC 71367

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