The RC company is considering a new product launch. The product launch will cost
ID: 2731555 • Letter: T
Question
The RC company is considering a new product launch. The product launch will cost $1,750,000, have a four year-life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 380 per year; price per unit will be $38,400, variable cost per unit will be $30,200, and fixed costs will be $690,000 per year. The required return on the project is 11%, and the relevant income tax rate is 35%.
a. Based upon RC's management's experience, they believe that unit sales, variable cost, and fixed cost projections stated above are likely to be accurate to within plus or minus 10%. What are the best and worse cases for the projection? What is the base case NPV? What are the best-case and worst-case scenarios for this proposed product launch?
b. Evaluate the sensitivity of the base case NPV to changes in (i) fixed costs, (ii) variable costs, (iii) the price per unit, and (iv) unit sales per year.
Explanation / Answer
a) Base Case NPV, Best-Case and Worst-case scenarios
Note: the depreciation is calculation by dividing the Product Launch Cost by its Life. The initial cost of the launch is not deducted from the NPV as we have included the depreciation in the calculation of NPV and for a period of 4 years.
b) Evaluation of the sensitivity
In all the 3 scenarios, NPV is positive @ expected return of 11% by the Management.
The NPV is $ 4,009,989 when 380 Units are sold.and the prices / cost are taken as given. Normally we believe that Increase in Units, will increase the NPV and viceversa. Interestingly, that may not be the case as to increase NPV, only one driver (Sale of Units) should not be considered. Other drivers such as Variable cost play a very important role. We can observe that the Contribution has decreased when higher units are sold. This is because, Variable costs also have increased. Further, the Profit Before Tax is also decreased further with increase of Fixed Cost. Normally, the Fixed Cost does not increase / decrease within a range. However, in this problem, it is specifically stated the Fixed Cost also varies. The cushion of Profit After Tax in the Best-case scenario is less when compared to Worst-Case scenario. Even if the Tax rate is changed or Additional Tax is levied by the Government, then in the Best-case scenario, the cushion of Profit After Tax will be reduced further, thereby increasing the risk of the Product Launch.
The Management is expecting that all the projections are valid until the Product Life, which is 4 years. This assumption has to be evaluated on the Political, Social and Economic conditions of the Market(s) where the Product will be sold.
Base Case NPV Units Amount Sales 380 $ 14,592,000 Less: Variable $ (11,476,000) Contribution $ 3,116,000 Less: Depreciation $ (437,500) Less: Fixed Cost $ (690,000) Profit before Tax $ 1,988,500 Less: Taxes @ 35% $ (695,975) Profit After Tax $ 1,292,525 NPV of PAT for 4 years $ 4,009,989 Best Case: 10% increase from Base Case Units Amount Sales 418 $ 16,051,200 Less: Variable $ (13,885,960) Contribution $ 2,165,240 Less: Depreciation $ (437,500) Less: Fixed Cost $ (759,000) Profit before Tax $ 968,740 Less: Taxes @ 35% $ (339,059) Profit After Tax $ 629,681 NPV of PAT for 4 years $ 1,953,551 Worst Case: 10% decrease from Base Case Units Amount Sales 342 $ 13,132,800 Less: Variable $ (9,295,560) Contribution $ 3,837,240 Less: Depreciation $ (437,500) Less: Fixed Cost $ (621,000) Profit before Tax $ 2,778,740 Less: Taxes @ 35% $ (972,559) Profit After Tax $ 1,806,181 NPV of PAT for 4 years $ 5,603,578Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.