Case $3$ Estimating Cash Flow $$ New Project Analysis

The Lazy Mower: Is It Really Worth It$?$

If there was one thing the folks at Innovative Products Inc. $($IPI$)$ knew well, 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$$s engineers and been pushed really hard to develop a prototype of a useful, and hopefully, highly profitable $$unique$$ product. Then, last month, the design team unveiled a fully$-$tested prototype of their latest innovation, the $$remotecontrolled$$ lawn mower, nick$-$named the $$The Lazy Mower.$$

Surveys of retailers and customers, conducted by the marketing department,

indicated that demand would be excellent, provided the price was lower than a riding lawn mower. The testing and development phases took almost $3$ years and final product passed all safety hazard tests with flying colors. After the unveiling, the product was exhibited at various home shows nationwide and received raving 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 Lazy

Mower, 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, Pete Fieldstone. As was typical in a major undertaking of this type, the proposal had to include detailed cost and revenue estimates with sufficient documentation to substantiate the numbers.

Having been involved with more than a few of these kinds of proposals before,

the head of the Design team, Dan Conklin, 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 Dan, his assistant, Ron Howard, who had recently earned his Chartered Financial Analyst $($CFA$)$ designation, was an experienced and dependable employee. Prior to being hired by CPC three years ago, Ron had worked for another large engineering company for over $10$ years. $$Ron$,$ we have to do all the $$i$$s$$ and cross all the $$t$$s$$ on this one!$$ said Dan. $$Or else, the big guys are going to tear us apart, coz we$$re talking major dollars here. Their main question is going to be$,$ IS IT REALLY WORTH IT$?$

So Dan and Ron 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;

$2.$ Sensitivity of the cash flows to alternative scenarios of sales growth and

profit margins;

Based on the data provided by the Marketing department, they prepared Table $1,$ showing the expected unit sales of the Lazy Mower over its $10-$year economic life and the expected selling price per unit. Note that the price of $$1000$ per unit was estimated to gradually drop to $$900$ per unit over the $10-$year period reflecting competitive pressures. Depreciation for this project was based on the $7-$year MACRS rates as shown in Table $2.$ The cost of equipment, including shipping, handling, and installation, 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 another firm, which will

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 $$400.$ The required rate of return is $15\%.$ The company$$s tax rate was expected to remain constant at $34\%.$

Table $1$ Projected Unit Sales and Price for Lazy Mower

Year Unit Sales Unit Price

$130000$ $$1000$

$234000$ $$1000$

$338800$ $$1000$

$438000$ $$950$

$536000$ $$950$

$636000$ $$950$

$735500$ $$950$

$835000$ $$900$

$934500$ $$900$

$1034000$ $$900$

Table $2$ Modified ACRS Depreciation Allowances

Year $3-$Year $5-$Year $7-$Year

$133\mathrm{.}33\%20\mathrm{.}00\%14\mathrm{.}29\%$

$244\mathrm{.}44\%32\%24\mathrm{.}49\%$

$314\mathrm{.}82\%19\mathrm{.}2\%17\mathrm{.}49\%$

$47\mathrm{.}41\%11\mathrm{.}52\%12\mathrm{.}49\%$

$511\mathrm{.}52\%8\mathrm{.}93\%$

$65\mathrm{.}76\%8\mathrm{.}93\%$

$78\mathrm{.}93\%$

$84\mathrm{.}45\%$

Questions: $6.$ Calculate the NPV of the project. Based on your calculations what would you recommend? Why?

$7.$ Calculate the IRR of the project. Based on your calculations what would you

recommend? Why?