ABC Corporation is thinking of producing and selling a new type of smoke detector. They have gathered together their best estimate of anticipated costs as presented below.

a.            New equipment to produce the smoke detector would cost $100,000. It would be usable for 10 years. After 10 years, it would have a salvage value equal to 10% of the original cost. However, for tax purposes this equipment will be treated as 5 year property based on the full cost with ½ year’s worth of depreciation the first and last year (affects 6 yrs of tax returns). This depreciation method is called Straight Line Accelerated Cost Recovery System with ½ year convention.

b.            Production and sales of the smoke detector would require a working capital investment of $40,000 to finance accounts receivable, inventories, and date to day cash needs. This working capital would be released for use elsewhere after 10 years.

c.             A marketing study projects an increase in sales for 8000 units per year on average over the next 10 years:

d.            The smoke detectors would sell for $45 each; variable costs for production, administration, and advertising are expected to average $25 per unit.

e.            The company will have advertising costs of $50,000 per year.

f.             Other fixed costs for salaries, insurance, and maintenance would total $80,000 per year. Excludes SL accounting depreciation.

g.            The machine will need a major overhaul (repair costs) in year 7 for $20,000.

h.            Accounting depreciation book depreciation is based on cost less salvage over 10 years.

i.              The company’s borrowing rate is 10% before taxes. They have a 40% tax rate.

Compute the NPV and PI. Approximate the ARR and Payback. Think about how to compute IRR – does it appear to be higher or lower than the discount rate used –change rate until you get ZERO NPV. How to attack the problem: First figure out what the recurring every year revenue and expenses are w/out depreciation and summarize in a subtotal. Put basic items in a list then make a second pass through the list deciding whether the each listed item has a tax effect. Also do tax effect for depreciation – depreciation was not a cash flow, but its tax savings is a cash flow. Then apply appropriate PV factors.