Cash flow Estimation and Capital Budgeting

XYZ Electronics, Inc. is a manufacturer of eBook Readers. Its current model is selling excellently. However, in order to cope with the foreseeable competition with other like eBook Reader models such as Kindle Fire, Nook Tablet or BeBook Neo, WE spent $2,580,000 to develop a prototype for a new eBook Reader model that includes both features of the existing model and some new features such as enhanced touch screen, less bulky and faster and wider Wi-Fi access. The company had also spent a further $635,500 to study the marketability of this new model. WE is able to manufacture the new model at a variable cost of $95 per unit. The total fixed costs for the operation are expected to be $4.5 million per year. WE expects to sell 6,500,000 units, 5,500,000 units, 5,000,000 units, 3,500,000 units and 2,500,000 units of this new model per year over the next five years respectively. The new model will be selling at a price of $199 per unit. To launch this new line of production, WE needs to invest $680 million in equipment which will be depreciated on a seven-year MACRS schedule. The value of the used equipment is expected to be $43.7 million as at the end of the 5 year project life.

WE is planning to stop producing the existing model entirely in two years. Should WE not introduce the new model, sales of the existing model will be 4,850,000 units and 2,650,000 units for the next two years respectively. The existing model can be produced at variable costs of $70 per unit and total fixed costs of $3.8 million per year. The old model is selling for $145 per unit. If WE produces the new model, sales of existing model will be eroded by 1,000,000 units and 1,500,000 units for the next two years respectively. In addition, to promote sales of the existing model alongside with the new model, WE has to reduce the price of the existing model to $115 per unit. Net working capital for the new eBook Reader production will be 15 percent of sales and will vary with the occurrence the cash flows. As such, there will be no initial NWC required. The first change in NWC is expected to occur in Year 1 according to the sales of the year. WE is currently in the tax bracket of 35 percent and it requires an 20 percent returns on all of its projects. Your company has just been hired by WE as a financial consultant to advise them on this new eBook Reader project. You are expected to provide answers to the following questions to their management by their next meeting which is scheduled sometime next month.

1. What is/are the sunk cost(s) for this new eBook Reader project? Briefly explain. You have to tell what sunk cost is and the amount of the total sunk cost(s). In addition, you have to advise WE on how to handle such cost(s).

2. What are the cash flows of the project for each year?

3. What is the payback period of the project? Should it be accepted if WE requires a payback of 3 years for all projects?

4. What is the PI (profitability index) of the project?

5. What is the IRR (internal rate of return) of the project?

6. What is the NPV (net present value) of the project?

7. Should the project be accepted based on PI, IRR and NPV? Briefly explain.