Pointless Luxuries Inc. (PLI) produces unusual gifts targeted at wealthy consumers. The company is analyzing the possibility of introducing a new device designed to attach to the collar of a cat or dog. This device emits sonic waves that neutralize airplane engine noise, so that pets traveling with their owners can enjoy a more peaceful ride. PLI estimates that developing this product will require up-front capital expenditures of $10 million. These costs will be depreciated on a straight-line basis for five years. PLI believes that it can sell the product initially for $250. The selling price will increase to $260 in years 2 and 3 before falling to $245 and $240 in years 4 and 5, respectively. After five years the company will withdraw the product from the market and replace it with something else. Variable costs are $135 per unit. PLI forecasts sales volume of 20,000 units the first year, with subsequent increases of 25% (year 2), 20% (year 3), 20% (year 4), and 15% (year 5). Offering this product will force PLI to make additional investments in receivables and inventory. Projected end-of-year balances appear in the following table.

The firm faces a tax rate of 34 percent. Assume that cash flows arrive at the end of each year, except for the initial $10 million outlay.
a. Calculate the project€™s contribution to net income each year.
b. Calculate the project€™s cash flows each year.
c. Calculate two NPVs, one using a 10 percent discount rate and one using a 15 percent discount rate.
d. A PLI financial analyst reasons as follows: €œWith the exception of the initial outlay, the cash flows from this project arrive in more or less a continuous stream rather than at the end of each year. Therefore, by discounting each year€™s cash flow for a full year, we are understating the true NPV. A better approximation is to move the discounting six months forward (e.g., discount year-1 cash flows for six months, year-2 cash flows for 18 months, and so on), as if all the cash flows arrive in the middle of each year rather than at the end.€ Recalculate the NPV (at 10% and 15%) maintaining this assumption. How much difference does it make?

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Year 0 Year Year 2 Year 3 Year 4 Year 5 S0 $200,000 S250,000 S300,000 S150,000 SO Accounts receivable Inventory 0 500,000 650,000 780,000 600,000