11 Estimating Cash Flow-New Project Analysis The Lawn Robot: Is It Really Worth It? If there was one thing the folks at Creative Products Corporation (CPC) knew it was how to come up with useful and unique products in the midst of economic adversity. With current year revenues considerably lower and profit margins shrinking due to severe price competition, the firm's engineers had been pushed hard to develop a prototype of a useful, and hopefully highly profitable, "unique" product. Last month, the design team unveiled a fully tested, prototype of their latest innovation, a remote- controlled lawn mower, the "Lawn Robot." Surveys of retailers and customers conducted by the marketing depart- ment indicated that demand would be excellent, provided the price was lower than a riding lawn mower. The testing and development phases took almost three years and the final product passed all safety hazard tests with flying colors. After the unveiling, the product was exhibited at various home shows nationwide and received rave reviews. Full production had not yet started, however, because there had been a change in CEOs, and the new CEO was highly conservative. Before being given the go ahead to go into full-scale production of the Lawn Robot, the design team had to present a detailed feasibility study to the Capital Investment Committee (CIC), which was chaired by the Vice President of Finance, Bill Burton. As was typical in a major under- taking of this type, the proposal had to include detailed cost and revenue estimates with sufficient documentation to substantiate the numbers. 44 45 Case 11 The Lawn Robot: Is It Really Worth It? Having been involved with more than a few of these kinds of proposals before, the head of the design team, Matt Robichek, knew that he had better take every possible factor into consideration and be prepared for a tough and demanding question and answer session at the next committee meeting. Luckily for Matt, his assistant, Chris Robinson, who had recently earned his chartered financial analyst (CFA) designation, was an experi- enced and dependable employee. Prior to being hired by CPC three years ago, Chris had worked for another large engineering company for over 10 years. "Chris, we have to dot all the 'i's' and cross all the it's' on this one!" said Matt. "Or else the big guys are going to tear us apart, because we're talking major dollars here. Their main question is going to be, is it really worth it?" So Matt and Chris began collecting the necessary information. They knew that to have a comprehensive feasibility study they would have to include the following: 1. Pro forma statements showing expected annual revenues, variable costs, fixed costs, and net cash flows over the economic life of the project with appropriate supporting documentation. 2. Break-even analysis. 3. Sensitivity of the cash flows to alternative scenarios of sales growth and profit margins. Anot Alison Based on the data provided by the marketing department, they prepared Table 1, showing the expected unit sales of the Lawn Robot over its 10-year economic life and the expected selling price per unit. Note that the price of $1,000 per unit was estimated to gradually drop to $900 per unit over the 10-year period reflecting competitive pressures. Depreciation for this project was based on the seven-year MACRS rates as shown in Table 2. The cost of equipment, including shipping, handling, and instal- lation, was estimated at $20 million. It was estimated that after 10 years, the equipment and tools could be sold for $4 million. The manufacturing would be done in an unused plant of the firm. Similar plant locations could be leased for $10,000 per month. Fixed costs were estimated to be $1,500,000 per year while variable production costs per unit were expected to be $400. To get the project underway, additional inventory of $500,000 would be required. The company would increase its accounts payable by $600,000 and its accounts receivable by $1,000,000. Matt and Chris estimated that each year thereafter, the net working capital of the firm would amount to 5% of sales. The weighted average cost of capital was calculated to be 14%. Interest expenses on debt raised to fund the project were estimated to be $400,000 per year. The company's tax rate was expected to remain constant at 34%. A. Briefly, summarize the key facts of the case, identify the problem/decision, and explain why it is important. B. I have provided the case data on a spreadsheet in the Week 5 section in the Weekly Materials and Assignments folder on D2L. Based on the data and information provided in the case, please respond to the following questions: 1. Prepare a pro forma statement showing the annual cash flows resulting from the Lawn Robot project, and compute the NPV and IRR of the project. In addition to this base case, also consider the following two scenarios: (i) Sales forecasts are 15% worse (pessimistic) and (ii) sales forecasts are 15% better (optimistic). (Note that you need to compute cash flows as well as the NPV and IRR for each of these scenarios.) Hint: When computing cash flows, note that Net Working Capital investments for each year is not the entire amount of 5% of sales revenues, but only the change in the Net Working Capital over the previous year. Go over the example in Table 6.1 in section 6.2 of the Ross textbook. 2. Say the company has already spent $500,000 in developing the prototype of the Lawn Robot. How should Matt and Chris treat this item in computing the project cash flo Explain. Also, explain whether or not the annual interest expenses of $400,000 should be included in the cash flows. 3. Perform a sensitivity analysis showing how the NPV of the project would change in response to changes in the following variables: a) Sales quantity, b) Sales price, c) Variable cost and d) WACC. Interpret the results. 4. Using the base case estimates calculate the cash, accounting, and financial break-even of the Lawn Robot project. Interpret each one. Hint: The financial break-even point of the project is the annual sales quantity that results in the project having a zero NPV. You can either use the formula on page 212 of the Ross textbook, or trial and error, or the Goal Seek functionality in Excel. 5. What other types of contingent planning should Matt and Chris include in their report? Provide some rationale or explanation for your suggestions. Hint: Refer to chapter 7 of the Ross textbook. C. Based on the analysis above, what is your recommendation? Should the firm go ahead with the project or not? Justify your recommendation by highlighting the key results of your analysis. Also, include any limitations of the analysis