Capital budgeting

Groves Industrial currently produces the Slim-Line iPod. Groves has spent $700,000 of R&D to develop a new model, the Soft-Touch iPod. The company has also spent $250,000 for a marketing study to determine the expected sales gures for the Soft-Touch iPod. Critical information for the Soft-Touch iPod is: 0 Average variable cost per unit is $140.00 0 Product life cycle is ve years 0 Incremental fixed costs per year of $5,000,000 0 Sales quantity per year 70,000, 90,000, 100,000, 85,000 and 75,000 0 Selling price per unit is $350.00 I Soft-Touch equipment costs are $17,000,000 o MACRS 7 year depreciation rates: Year 1 - 14.29%, Year 2 - 24.49%, Year 3 - 17.49%, Year 4 - 12.49%, Year 5 - 8.93% 0 At the end of the product life cycle, the equipment will have an estimated salvage value of $3,500,000 Slim-Line data assuming no Soft-Touch product introduction: 0 Production is scheduled to end in two years 0 Sales quantity is expected to be 80,000 and 60,000 units 0 Unit selling price is $260 and unit variable cost is $120 0 Fixed costs are $2,000,000 per year Introducing the Soft-Touch iPod will erode Slim-Line sales: 0 Slim-Line sales will decrease by 15,000 units in years 1 & 2 0 Slim-Line selling price will need to be lowered to $220.00 for the remaining sales quantity Tax rate is 35% Net Working Capital: 0 Accounts Receivable will be 10% of net sales for years 1 to 4 o Inventnrv will he 15% of net variable costs for years 1 to 4 Net Working Capital: 0 Accounts Receivable will be 10% of net sales for years 1 to 4 0 Inventory will be 15% of net variable costs for years 1 to 4 0 Accounts Payable will be 10% of net variable costs for years 1 to 4 o NWC balances will be reversed in year 5, there will be no ending balances 10% Cost of Capital, NPV Rates: Year 0 -1.000, Year 1 - 0.9091, Year 2 0.8264, Year 3 0.7513, Year 4 0.6830, Year 5 0.6209 Case Requirements: Determine the Net Present Value and Payback Periods for the project and provide a recommendation to Groves Industrial on whether they should proceed with introducing the Soft-Touch iPod. Additional details: 0 Introducing Soft-Touch product line will have adverse effect or erosion on the planned Slim-Line sales. 0 Lost sales quantity of 15,000 units and reduced variable costs in years 1 and 2. 0 $40 Selling price decrease for the remaining sales quantity for years 1 and 2. 0 Only the changes in the Slim-Line cash ows that are driven by the introduction of Soft-Touch product line are reected in the project analysis. 0 Year 5 Depreciation Adjustment Purchase Price of the Equipment Less Salvage Value Depreciation Tax Credit Allowed Less 5 years MACRS Depreciation Depreciation Adjustment 0 The cash salvage value is recorded in the Cash Flow section because it isn't taxable. 0 At the end of the product life cycle, there will be no Net Working Capital balances. All of the accounts receivable will be collected, the inventory will be used in production and the accounts payable balances will be paid. Overview of the Groves Industrial Case Basic Premise - R&D has developed a potential new product, the Soft- Touch iPod. A marketing study indicates there is a potential market for the new product. The question is, should we manufacture and sell Soft- Touch iPods? The analysis should only reflect the impact of the Soft- Touch iPod product introduction. Proceed with Soft-touch R&D Marketing study Decision Developed a > confirms a -> Point new iPod potential market Drop Soft-touch Net Income Statement: Soft-Touch Slim-Line Erosion New Sales (Reduced Sales Volume) (Variable Costs) Avoided Variable Costs (Fixed costs) (Lower Selling Prices) (Depreciation) Net before Taxes Net before Taxes