you have taken a job with a local manufacturing company. Your boss has asked you

Question

you have taken a job with a local manufacturing company. Your boss has asked you to analyze a potential new product, and to recommend if the company should produce and sell the product. Specifically, your boss wants you to prepare a spreadsheet that shows the free cash flows the product would generate, and shows what the product’s net present value and internal rate of return are and what your recommendation is (see Table 12.1 in the textbook). Marketing information Your company already has spent $100,000 to conduct market research about the demand for the product, which indicates the optimal wholesale price for the product would be $15.00 per unit, based on the prices of similar products that competitors sell. The market research also indicates that demand for the product would last for five years. At a price of $15.00 per unit, the market research suggests that sales would be 250,000 units in the first year, and unit sales would increase 8% per year over the remaining four years of the product’s life. Production information Your company’s production manager estimates manufacturing the product would require a machine that costs $850,000, and falls in the 3-year MACRS depreciation class. The machine’s expected salvage value in five years is expected to be $100,000. The production manager also estimates the product’s variable costs, consisting of raw materials and labor, would be $12.50 per unit, and the annual fixed costs excluding depreciation would be $350,000. He states the product could be manufactured in a building your company owns, which has no other use. Financial information Your company’s stock price is $41.70 per share, the last annual dividend was $2.25 per share, and market analysts who follow your company’s stock expect the dividends to grow forever at a rate of 6.0% per year. The company’s beta is 1.4 and Treasury bills are paying 2.7% per year. The company’s bonds have a par value of $1,000, pay a coupon of 5.5% per year, semiannually, have 12 years to maturity, and are trading at $958. The company’s treasurer estimates that the new product would require a $400,000 increase in net working capital. She also has told you the company’s target capital structure is 60% debt and 40% equity, the company’s tax rate is 25%, and she expects the stock market return over the next year will be 9.0%.

Explanation / Answer

Calculation of free cash flow in next 5 yrs Year 1 2 3 4 5 Sales(units) 250000 270000 291600 314928 340122.2 Unit Price 15 15 15 15 15 Sales(Amt in $) 3750000 4050000 4374000 4723920 5101834 Less : Variable cost 3125000 3375000 3645000 3936600 4251528 Annual Fixed cost 350000 350000 350000 350000 350000 Depreciation 283305 377825 125885 62985 Net Income -8305 -52825 253115 374335 500305.6 Tax 0 0 63278.75 93583.75 125076.4 Net Income (After tax) -8305 -52825 189836.3 280751.3 375229.2 Add: Depreciation 283305 377825 125885 62985 Free Cash flow 275000 325000 315721.3 343736.3 375229.2 MACRS Class 3 depreciation Rate 1 33.33% 2 44.45% 3 14.81% 4 7.41% Calculation of cost of capital Cost of Debt 5.50% After Tax cost of debt 4.13% Weight of Debt 60% Cost of Equity As per CAPM model, cost of equity = Risk-free rate of return + Beta*(Market rate of return-Risk free rate of return) 2.7%+1.4(9%-2.70%) 11.52% Weight of Equity 40% Cost of capital = 4.13%*0.60 + 11.52%*0.40 7.09% Year Cash flow Discount factor @ 7.09% 0 -1250000 1 -1250000 1 275000 0.933794 256793.4 2 325000 0.871971 283390.7 3 315721.3 0.814242 257073.4 4 343736.3 0.760334 261354.3 5 375229.2 0.709995 266410.9 Net Present Value 75022.67

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