Holmes Electronics' Canadian Branch will help introduce into Canada the just developed new electronic device which, when mounted on an automobile, will tell the driver how many miles the automobile is getting per gallon of gasoline. The device can be mounted on any model of automobile in a few minutes time for negligible cost.
The company is anxious to begin production and distribution of the new device. To this end, marketing and cost studies have been made to determine probable costs and market potential. These studies have provided the following information:
a. New equipment would have to be acquired in order to produce the device. The equipment would cost $365,000 and have a 12-year useful life. After 12 years, the equipment would have a salvage value of about $25,000.
b. Sales in units over the next 12 years are projected to be as follows:
Year Sales in units
1 ......................... 10,000
2 ....................... 16,000
3 ......................... 19,000
4-12 .................... 22,000
c. Production and sales of the device would require working capital of $82,000 in order to finance accounts receivable, inventories and day-to-day cash needs. This working capital would be released at the end of the project's life.
d. The devices would sell for $35 each; variable costs of production, administration & sales would be $15 per unit.
e. Fixed costs for salaries, maintenance, property taxes, insurance and MACRS 7-year depreciation on the equipment would total $135,000 per year. (Depreciation is based on original cost times the MACRS depreciation %'s per year, using the ½ year convention: Yr1=14.29%; Yr2=24.49%; Yr3=17.49%; Yr4=12.49%; Yr5=8.93%; Yr6=8.92%; Yr7=8.93% and Yr8=4.46%.) No depreciation would be taken after year 8.
f. In order to gain rapid entry into the market, the company would have to advertise heavily. The advertising program would be:
Years 1-2 ................................ $ 125,000 per year
Year 3 ................................ 110,000 per year
Years 4-12 ............................. 80.000 per year
g. Holmes Electronics' Board of Directors has specified that all new product lines must promise a return of at least 14% (percent) in order to be acceptable (& must be acceptable in Canada as well).
h. The average income tax rate to use in this analysis is 40%
Required (label each answer prominently):
1. Compute the net cash inflow (cash receipts less yearly cash operating expenses) anticipated from the sale of the device for each of the 12 years.
2. Using the data from 1. above and other data in the problem, determine the NPV (net present value) of the proposed investment.
3. Compute the IRR (internal rate of return) use interpolation.
4. Based on the decision criteria available, should the project be accepted? Why or why not?