You work for Mattel, a profitable toy manufacturer, and you are negotiating with

Question

You work for Mattel, a profitable toy manufacturer, and you are negotiating with Warner Brothers for the rights to manufacture and sell Harry Potter lunchboxes (you already sell related action figures). Your marketing department estimates that you can sell $800 million worth of lunchboxes per year for 3 years, starting next year. At the end of year 3, you will liquidate the assets of the business.   Given the following information about this new product investment, identify the relevant cash flows, and calculate the investment's net present value, benefit-cost ratio, and internal rate of return. Make whatever assumptions you feel necessary and explain them briefly. ($ in thousands) Marketing Research Costs, to date $         20,000 Initial cost of new equipment $       300,000 Licensing rights to use images (To be expensed for tax purposes at time 0) $       350,000 Expected life 5 yrs Salvage value 0 Depreciation method Straight-line over 5 years to 0 salvage value Selling price of new equipment in 3 years* $       130,000 Incremental annual sales $       800,000 Incremental annual production costs $       200,000 Incremental annual selling      and administrative costs $         80,000 Current annual overhead costs $       200,000 Immediate advertising expenses for launch (To be expensed for tax purposes at tme 0) $       190,000 Tax rate 40% Working capital required, as a % of production costs 7.50% (Needed at time 0.) Minimum required rate of return 10% *The company must pay a 40% tax on the difference between the selling price and the asset's book value at time of sale. You work for Mattel, a profitable toy manufacturer, and you are negotiating with Warner Brothers for the rights to manufacture and sell Harry Potter lunchboxes (you already sell related action figures). Your marketing department estimates that you can sell $800 million worth of lunchboxes per year for 3 years, starting next year. At the end of year 3, you will liquidate the assets of the business.   Given the following information about this new product investment, identify the relevant cash flows, and calculate the investment's net present value, benefit-cost ratio, and internal rate of return. Make whatever assumptions you feel necessary and explain them briefly.

Explanation / Answer

Step 1: Calculate the Initial Cash Flow in Year 0

Initial Cash Flow = -Cost of New Equipment - Licensing Rights to Use Images*(1-Tax Rate) - Immediate Advertising Expenses for Launch*(1-Tax Rate) - 7.5% of Annual Production Costs

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Using the information provided in the question, we get,

Initial Cash Flow = -300,000 - 350,000*(1-40%) - 190,000*(1-40%) - 7.5%*200,000 = -$639,000

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Step 2: Calculate Annual Cash Flow in Year 1 to Year 3

The calculation of annual cash flow has been shown in the following table:

Assumptions:

1) Current annual annual overhead costs are assumed to be accounted for in incremental annual production costs.

2) Working capital is assumed to be recovered in the year of liquidation of business.

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Step 3: Calculate NPV, Benefit Cost Ratio and IRR

NPV is the difference between the present value of cash inflows and cash outflows. The net present value can be calculated with the use of following formula:

Net Present Value = Cash Flow Year 0 + Cash Flow Year 1/(1+Required Return)^1 + Cash Flow Year 2/(1+Required Return)^2 + Cash Flow Year 3/(1+Required Return)^3

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Using the values calculated in Step 1 and Step 2, we get,

NPV = -639,000 + 336,000/(1+10%)^1 + 336,000/(1+10%)^2 + 477,000/(1+10%)^3 = $302,517.66

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The benefit cost ratio can be calculated with the use of following formula:

Benefit-Cost Ratio = Present Value of Cash Inflows/Initial Investment

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Using the values calculated in Step 1 and Step 2, we get,

Present Value of Cash Inflows = 336,000/(1+10%)^1 + 336,000/(1+10%)^2 + 477,000/(1+10%)^3 = $941,517.66

Benefit Cost Ratio = 941,517.66/639,000 = 1.47

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IRR is the minimum acceptable rate of return from a project at which NPV is 0. IRR can be calculated with the use of IRR function of EXCEL/Financial Calculator. The basic formula for calculating IRR is:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3

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IRR has been calculated with the use of EXCEL as follows:

IRR = 33.68%

Year 1 Year 2 Year 3 Incremental Annual Sales 800,000 800000 800000 Less Incremental Annual Production Costs 200,000 200,000 200,000 Incremental Annual Selling and Administrative Costs 80,000 80,000 80,000 Depreciation (300,000/5) 60,000 60,000 60,000 Incremental Savings Before Tax 460,000 460,000 460,000 Less Tax 184,000 184,000 184,000 Incremental Savings After Tax 276,000 276,000 276,000 Add Depreciation 60,000 60,000 60,000 Sales Value of Equipment after 3 Years 0 0 130,000 Tax on Gain (130,000 – 120,000)*40% 0 0 -4,000 Recovery of Working Capital (7.5%*200,000) 0 0 15,000 Cash Flow $336,000 $336,000 $477,000

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