Reliable Electric is considering a proposal to manufacture a new type of industrial electric motor that would replace most of its existing product line. A research breakthrough has given Reliable a 2-year lead on its competitors. The project proposal is summarized in Table 9.3. Read the notes to the table, and in each case, explain whether the note makes sense or not.
a. Capital investment: $8 million for new machinery and $2.4 million for a warehouse extension. The full cost of the extension has been charged to this project, although only about half the space is currently needed. Because the new machinery will be housed in an existing factory building, no charge has been made for land and building.
b. Research and development: $1.82 million spent in 2016. This figure was adjusted for 10% inflation from the time of expenditure to date. Thus, 1.82 × 1.1 = $2 million.
c. Working capital: Initial investment in inventories.
d. Revenue: These figures assume sales of 2,000 motors in 2018, 4,000 in 2019, and 10,000 per year from 2020 through 2027. The initial unit price of $4,000 is forecasted to remain constant in real terms.
e. Operating costs: These include all direct and indirect costs. Indirect costs (heat, light, power, fringe benefits, etc.) are assumed to be 200% of direct labor costs. Operating costs per unit are forecasted to remain constant in real terms at $2,000.
f. Overhead: Marketing and administrative costs, assumed equal to 10% of revenue.
g. Depreciation: Straight-line for 10 years.
h. Interest: Charged on capital expenditure and working capital at Reliable's current borrowing rate of 15%.
i. Income: Revenue less the sum of research and development, operating costs, overhead, depreciation, and interest.
j. Tax: 35% of income. However, income is negative in 2017. This loss is carried forward and deducted from taxable income in 2019.
k. Net cash flow: Assumed equal to income less tax.
l. Net present value: NPV of net cash flow at a 15% discount rate.