Need help with what are the sunk costs, and cash flows for each year
Rainbow RV, Inc. is a manufacturer of recreational vehicles. Its current line of truck campers are selling very well. However, since there are also other well established truck camper manufacturers in the area, competition is very keen among them. In order to cope with this competition, Rainbow spent $1,550,000 to develop a new line of premium truck campers that are more spacious and functional. This new camper model incorporates a lightweight electric slide-out galley area. Its u- shaped dinette/lounge can easily be converted into an additional bed. The lightweight truck camper has a standard bathroom with shower and toilet. Its kitchen is featured with a slide-in cooktop with drawers below, a stainless steel domestic four-cubic feet 2-way refrigerator and a fan exhaust roof vent. The camper fits all short-bed trucks 6' - 6.5' - 6.75'. The company had also spent a further $450,000 to study the marketability of this new model. Rainbow is able to produce the new model at a variable cost of $9,750 each. The total fixed costs for the operation are expected to be $3,850,000 per year. Rainbow expects to sell 25,000 campers, 30,000 campers, 20,000 campers, 18,000 campers and 13,000 campers of the new premium model per year over the next five years respectively. They will be selling at a price of $22,000 each. For this new line of production to start, Rainbow needs to invest $550,000,000 in equipment. The equipment will be depreciated on a seven-year MACRS schedule. The value of the used equipment is expected to be worth $8,950,000 as at the end of the 5 year project life. Rainbow will stop producing the existing model entirely in two years. If Rainbow does not make the new premium model, sales per year of the existing model will be 18,000 campers and 15,000 campers for the next two years respectively. The existing model can be produced at variable costs of $8,260 each. The existing model also requires a total fixed costs of $2,450,000 per year. They are selling for $19,500 each. If Rainbow produces the new premium model, sales of the existing model will drop by 4,000 campers for next year and 8,000 campers for the year after next. In addition, to promote sales of the existing model alongside with the new premium model, Rainbow has to reduce the price of the existing model to $15,000 each. Net working capital for the new premium model will be 20 percent of sales and will vary with the occurrence of the cash flows. Because of this, there will be no initial requirement of NWC. However, the first change in NWC is expected to occur in year 1 in accordance with the sales of the year. Rainbow is currently paying income taxes at 35 percent and it requires a 15 percent returns on all of its projects. As Rainbow's financial manager, one of your job responsibilities is to advise the company on this new premium truck camper project. You are expected to provide answers to the following questions to the CEO by the fifteenth of next month. 1. What is/are the sunk cost(s) for this new premium truck camper project? Briefly explain. You have to tell what sunk cost is and the amount of the total sunk cost(s). In addition, you have to advise the CEO on how to handle such cost(s). 2. What are the cash flows of the project for each year? 3. What is the payback period of the project? Should it be accepted if Rainbow requires a payback of 4 years for all projects? 4. What is the PI (profitability index) of the project? 5. What is the IRR (internal rate of return) of the project? 6. What is the NPV (net present value) of the project? 7. Should the project be accepted based on PI, IRR and NPV? Briefly explain. Rainbow RV, Inc. is a manufacturer of recreational vehicles. Its current line of truck campers are selling very well. However, since there are also other well established truck camper manufacturers in the area, competition is very keen among them. In order to cope with this competition, Rainbow spent $1,550,000 to develop a new line of premium truck campers that are more spacious and functional. This new camper model incorporates a lightweight electric slide-out galley area. Its u- shaped dinette/lounge can easily be converted into an additional bed. The lightweight truck camper has a standard bathroom with shower and toilet. Its kitchen is featured with a slide-in cooktop with drawers below, a stainless steel domestic four-cubic feet 2-way refrigerator and a fan exhaust roof vent. The camper fits all short-bed trucks 6' - 6.5' - 6.75'. The company had also spent a further $450,000 to study the marketability of this new model. Rainbow is able to produce the new model at a variable cost of $9,750 each. The total fixed costs for the operation are expected to be $3,850,000 per year. Rainbow expects to sell 25,000 campers, 30,000 campers, 20,000 campers, 18,000 campers and 13,000 campers of the new premium model per year over the next five years respectively. They will be selling at a price of $22,000 each. For this new line of production to start, Rainbow needs to invest $550,000,000 in equipment. The equipment will be depreciated on a seven-year MACRS schedule. The value of the used equipment is expected to be worth $8,950,000 as at the end of the 5 year project life. Rainbow will stop producing the existing model entirely in two years. If Rainbow does not make the new premium model, sales per year of the existing model will be 18,000 campers and 15,000 campers for the next two years respectively. The existing model can be produced at variable costs of $8,260 each. The existing model also requires a total fixed costs of $2,450,000 per year. They are selling for $19,500 each. If Rainbow produces the new premium model, sales of the existing model will drop by 4,000 campers for next year and 8,000 campers for the year after next. In addition, to promote sales of the existing model alongside with the new premium model, Rainbow has to reduce the price of the existing model to $15,000 each. Net working capital for the new premium model will be 20 percent of sales and will vary with the occurrence of the cash flows. Because of this, there will be no initial requirement of NWC. However, the first change in NWC is expected to occur in year 1 in accordance with the sales of the year. Rainbow is currently paying income taxes at 35 percent and it requires a 15 percent returns on all of its projects. As Rainbow's financial manager, one of your job responsibilities is to advise the company on this new premium truck camper project. You are expected to provide answers to the following questions to the CEO by the fifteenth of next month. 1. What is/are the sunk cost(s) for this new premium truck camper project? Briefly explain. You have to tell what sunk cost is and the amount of the total sunk cost(s). In addition, you have to advise the CEO on how to handle such cost(s). 2. What are the cash flows of the project for each year? 3. What is the payback period of the project? Should it be accepted if Rainbow requires a payback of 4 years for all projects? 4. What is the PI (profitability index) of the project? 5. What is the IRR (internal rate of return) of the project? 6. What is the NPV (net present value) of the project? 7. Should the project be accepted based on PI, IRR and NPV? Briefly explain
