A manufacturing company is thinking of launching a new product. The company expects to sell $950,000 of the new product in the first year and $1,500,000 each year thereafter. Direct costs including labor and materials will be 45% of sales. Indirect incremental costs are estimated at $95,000 a year. The project requires a new plant that will cost a total of $1,500,000, which will be a depreciated straight line over the next 5 years. The new line will also require an additional net investment in inventory and receivables in the amount of $200,000.

Question

A manufacturing company is thinking of launching a new product. The company expects to sell $950,000 of the new product in the first year and $1,500,000 each year thereafter. Direct costs including labor and materials will be 45% of sales. Indirect incremental costs are estimated at $95,000 a year. The project requires a new plant that will cost a total of $1,500,000, which will be a depreciated straight line over the next 5 years. The new line will also require an additional net investment in inventory and receivables in the amount of $200,000.

Assume there is no need for additional investment in building the land for the project. The firm's marginal tax rate is 35%, and its cost of capital is 10%.

To receive full credit on this assignment, please show all work, including formulae and calculations used to arrive at financial values.

Assignment Guidelines

Using the information in the assignment description:
Prepare a statement showing the incremental cash flows for this project over an 8-year period.
Calculate the payback period (P/B) and the net present value (NPV) for the project.
Answer the following questions based on your P/B and NPV calculations:
Do you think the project should be accepted? Why?
Assume the company has a P/B (payback) policy of not accepting projects with life of over 3 years.
If the project required additional investment in land and building, how would this affect your decision? Explain.
Your submitted assignment (125 points) must include the following:

A double-spaced Word document of 2–3 pages that contains your calculation values, your complete calculations, any formula that you used, and your answers to the two questions listed in the assignment guidelines.
You must include your explanation of how you used Excel for your calculations if applicable.

Answer 1

To prepare a statement showing the incremental cash flows for this project over an 8-year period, we need to calculate the cash flows for each year by subtracting the costs from the sales.

Year 1:
Sales: $950,000
Costs: (45% of Sales) = 0.45 * $950,000 = $427,500
Indirect Costs: $95,000
Depreciation: ($1,500,000/5 years) = $300,000
Net Investment: $200,000

Incremental Cash Flow: Sales - Costs - Indirect Costs - Depreciation + Net Investment
= $950,000 - $427,500 - $95,000 - $300,000 + $200,000
= $327,500

Years 2-8:
Sales: $1,500,000
Costs: (45% of Sales) = 0.45 * $1,500,000 = $675,000
Indirect Costs: $95,000
Depreciation: ($1,500,000/5 years) = $300,000
Net Investment: $200,000

Incremental Cash Flow: Sales - Costs - Indirect Costs - Depreciation + Net Investment
= $1,500,000 - $675,000 - $95,000 - $300,000 + $200,000
= $630,000

Now, let's calculate the payback period (P/B) and the net present value (NPV) for the project.

Payback Period (P/B):
The payback period is the time it takes for the initial investment to be recovered. We need to determine the year in which the cumulative incremental cash flows exceed the initial investment.

The cumulative cash flow for year 1 is $327,500.

For subsequent years:
Cumulative Cash Flow = Cumulative Cash Flow from previous year + Incremental Cash Flow

Year 2:
Cumulative Cash Flow = $327,500 + $630,000 = $957,500

Year 3:
Cumulative Cash Flow = $957,500 + $630,000 = $1,587,500

Since the cumulative cash flows exceed the initial investment of $1,500,000 at the end of year 3, the payback period is 3 years.

Net Present Value (NPV):
The net present value is calculated by discounting the incremental cash flows to their present values and summing them up. We will use the cost of capital of 10% as the discount rate.

NPV = Sum of (Incremental Cash Flow / (1 + Discount Rate)^Year)

Year 1:
NPV1 = $327,500 / (1 + 0.10)^1 = $297,727.27

Years 2-8:
NPV2 = $630,000 / (1 + 0.10)^2 + $630,000 / (1 + 0.10)^3 + ... + $630,000 / (1 + 0.10)^8

Using the formula for the sum of a geometric series:
NPV2 = $630,000 * (1 - (1 + 0.10)^-7) / 0.10
NPV2 = $2,928,144.84

Now, let's answer the questions based on the P/B and NPV calculations.

Question 1: Do you think the project should be accepted? Why?
Based on the payback period (P/B) of 3 years, the project should be accepted because the initial investment will be recovered within the company's policy of 3 years. This indicates a relatively quick return on investment.

Question 2: Assume the company has a P/B (payback) policy of not accepting projects with a life of over 3 years. If the project required additional investment in land and building, how would this affect your decision? Explain.
If the project required additional investment in land and building, it would impact our decision. The additional investment would increase the initial investment, potentially extending the payback period beyond the company's policy of 3 years. In this case, the project may not be accepted, as it would not meet the required payback period.