Mars Incorporated is interested in going to market with a new fuel savings devic

Question

Mars Incorporated is interested in going to market with a new fuel savings device that attaches to electrically powered industrial vehicles. The device, code named "Python," promises to save up to 15% of the electrical power required to operate the average electric forklift. Mars expects that modest demand expected during the introductory year will be followed by a steady increase in demand in subsequent years. The extent of this increase in demand will be based on customer's expectations regarding the future cost of electricity, which is shown in Table 1. Mars expects to sell the device for $300 each, and does not expect to be able to raise its price over the foreseeable future Mars is faced with two alternatives: >Alternative 1: Make the device themselves, which requires an initial outlay of $500,000 in plant and equipment and a variable cost of $135 per unit Alternative 2: Outsource the production, which requires no initial investment, but incurs a per unit cost of $150 Click the icon to view Table 1 Assuming small increases in the cost of electrical power, compute the cash flows for each alternative. Over the next 5 years, which alternative maximizes the NPV of this project if the discount rate is 9%? Determine cash flows for alternative 1 and fill in the table below. (Enter your responses as whole numbers. Be sure to include a minus sign for cash outflows.) Cash inflow (outflow) Demand in Year devices 1,000 6,000 12,000 17,000 22,000 4

Explanation / Answer

We start with alternative 1:

Initial investment of $500,000

variable cost per unit = $135

Sale price = $300

Cash flow For the 1st year = Demand*Sale price - Demand*cost price  

= 1000(300 - 135) = 165000

Similarly, Cash flow For the 2nd year = 6000(300-135) = 990000

Cash flow For the 3rd year = 12000(300-135) = 1980000

Cash flow For the 4th year = 17000(300-135) = 2805000

Cash flow For the 5th year = 22000(300-135) = 3630000

NPV of the project when there are different cashflows for different years:

NPV = (C for Period 1 / (1 + R)1) + (C for Period 2 / (1 + R)2) + ...+ (C for Period x / (1 + R)x) - Initial Investment
C is the cash flow for that year and R is the discount rate = 9%

NPV = 165000/(1+9%) + 990000/(1+9%)2 + 1980000/(1+9%)3 + 2805000/(1+9%)4 + 3630000/(1+9%)5 - 500000

= 151376.15 + 833263 + 1528923.3 + 1987132.7 + 2359250.9 -500000

= $6,359,945.9

Now, Alternative 2:

Variable cost per unit = $150

Cash flow in 1st year = 1000(300-150) = 150000

Cash flow in 2nd year = 6000(300-150) = 900000

Cash flow in 3rd year = 12000(300-150) = 1800000

Cash flow in 4th year = 17000(300-150) = 2550000

Cash flow in 5th year = 22000(300-150) = 3300000

Using same formule for NPV as shown above:

NPV = 150000/(1+9%) + 900000/(1+9%)2 + 1800000/(1+9%)3 + 2550000/(1+9%)4 + 3300000/(1+9%)5

= 137614.7 + 757512 + 1389930.3 + 1806484.3 + 2144773.6

= $6,236,314.9

Comparing the NPVs for the both the alternatives we can find that the NPV for the alternative 1 with the option of making the device on our own has higher NPV hence more suitable.

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