Prepare an analysis of this capital budgeting problem, in which you compute the Net Present Value of Icky Goo and decide if Terrible should introduce Icky Goo. In the course of working through this case, some decisions need to be made that reasonable people might disagree about. You may make the simplifying assumption that cash flows occur once per year at the end of each year. Specifically, your assignment should include the following: 1) A summary describing your approach, your results, and a recommendation. Explain your reasoning including quantitative and any qualitative factors. 2) Many of the values given in the case are uncertain. Use sensitivity analysis to provide estimates of NPV over a range of possible values. (These should include the discount rate, sales, lifetime of the project, and anything else that you think may be important.) 3) Brief explanations of how you handled each of the following issues and how they affected your analysis: i. The $4 million spent on development and test marketing ii . Capital expenditures (i.e. purchase of machinery) iii. Depreciation iv. Lease payments Overhead vi. Profit erosion vii. Taxes vili. Inflation ix. The introduction of Yuck by the competitor The reputation of Terrible as an innovator xi. Any other issues 4) An appendix with tables of annual cash flows and the NPV analysis. V. X. Terrible Toys Terrible is an Ontario-based manufacturer of children's toys, and over the years it has pioneered a large number of products that are sold internationally. Some of these turned out to be fads, while others have become permanent fixtures of our popular culture. In both situations, Terrible's management has found ways to turn them into very lucrative opportunities for the company. Competition in the toy market is cut-throat, but by responding quickly and forcefully to competitive threats, Terrible has managed to do more cutting than bleeding. Their aggressiveness in the product markets has always been guided and disciplined by careful analysis, Said one senior executive, "Our big advantage over other companies is that we actually take toys seriously Recently a new threat has emerged. A competitor has introduced a product known as Yuck. It is a slimy miracle substance that will slide off of flat surfaces. When thrown by the handful at older people it sticks to their skin or clothing without staining or otherwise causing permanent physical damage. Yuck appears to the management of Terrible as a serious threat in part because it will erode sales of their own products, Ack and Silly Dough. Further to the extent that this type of product will generate new sales, they are anodious to get in on the action. This is, in many ways, the perfect toy." claims one of the company's analysts, "It brings out the worst in small children with relatively benign consequences for adults. Accordingly, the firm has spent $4 million over the past year developing and test marketing a new product, to be called Icky Goo. Icky Goo will have several advantages over the competitive product. It can be sold in a variety of fluorescent colours, as opposed to the mud brown of Yuck. It can also be scented in foul ways, so that adults will find it even more distasteful and children will therefore find it more amusing. The company plans to sell Icky Goo in Rotten-Egg Yellow, Ol-Spill Purple, Greasy Green, and Sewage Brown. Importantly, Terrible hopes that the introduction of Icky Goo will reinforce their reputation as a leading innovator in toy technology Based on extensive marketing and production analyses, the company has estimated the sales and costs associated with the product over its expected life. The expected future accounting profits are provided in the table below. The table is only intended as guidance - you should adjust any numbers that you think should be adjusted for the purpose of your recommendation. Terrible plans to launch the product with a media blitz that will cost $6 million for each of the first two years. Once the product is established, continuing advertising and promotional expenses will run about $2 million a year. To mass-produce the product, Terrible would have to purchase new equipment immediately at a cost of $32 million. The new equipment would have an expected life of four years, after which it would have to be replaced. It has no salvage value. Assume it is depreciated for tax purposes straight-line over the four years. Marketing Icky Goo would also require warehouse and trucking facilities. Rather than purchasing new facilities, the company would lease them at a rate of $4 million per year. This rate would be contractually fixed for eight years, and payable at the beginning of each year. The introduction of Icky Goo will create a unique problem for the company. To a moderate extent, it will draw sales away from the company's existing products Ack and Silly Dough. Estimates of the profit erosion are shown in the appended table. Because competitors have already introduced similar products, however, Terrible' financial analysts are uncertain how to treat this profit erosion As a matter of policy, Terrible allocates a portion of the company's general and administrative overhead costs to each product line. The addition in allocated overhead to the Inane Toys Division, which will be in charge of Icky Goo, will be $5 million per year, even though the new products would only create $2 million per year in incremental overhead expenses. Estimates of the after-tax profits for the new product line are provided in the table below. The analysis is restricted to 8 years because management feels that this reflects the likely product life for Icky Goo. Given the risks involved, management feels that a 12% nominal discount rate should be used. Inflation is expected to be 3% annually. (For clarity, you are encouraged to present your analysis in nominal terms.) Estimated Future Net Profits For Icky Goo (All figures in millions of dollars) 2021 15.00 2022 20.00 2024 15.00 annually from 2025 to 2028 12.00 Cases Sold Sales Cost of Goods Sold Depreciation Lease payments Advertising Overhead Operating Profit Taxes Net Profit Profit Erosion Adjusted Net Profit 45.00 22.50 8.00 4.00 6.00 5.00 60.00 30.00 8.00 4.00 6.00 5.00 2023 25.00 75.00 37.50 8.00 4.00 2.00 5.00 45.00 22.50 8.00 4.00 2.00 5.00 36.00 18.00 8.00 4.00 2.00 5.00 -0.50 -0.13 -0.37 2.00 -2.37 7.00 1.86 5.14 2.00 3.14 18.50 4.90 13.60 1.00 12.60 3.50 0.93 2.57 0.00 2.57 -1.00 -0.27 -0.74 0.00 -0.74 Cost of Goods Sold is 50% of Sales. Depreciation is computed using the straight-line method, a four-year life, zero salvage value, and based on the cost of the new equipment. Depreciation is always calculated in nominal terms. Terrible pays a combined federal and provincial marginal tax rate of 26.5%. It is now late 2020 you are asked to provide an analysis and a recommendation on whether to introduce Icky Goo. If approved, operations will begin immediately. Prepare an analysis of this capital budgeting problem, in which you compute the Net Present Value of Icky Goo and decide if Terrible should introduce Icky Goo. In the course of working through this case, some decisions need to be made that reasonable people might disagree about. You may make the simplifying assumption that cash flows occur once per year at the end of each year. Specifically, your assignment should include the following: 1) A summary describing your approach, your results, and a recommendation. Explain your reasoning including quantitative and any qualitative factors. 2) Many of the values given in the case are uncertain. Use sensitivity analysis to provide estimates of NPV over a range of possible values. (These should include the discount rate, sales, lifetime of the project, and anything else that you think may be important.) 3) Brief explanations of how you handled each of the following issues and how they affected your analysis: i. The $4 million spent on development and test marketing ii . Capital expenditures (i.e. purchase of machinery) iii. Depreciation iv. Lease payments Overhead vi. Profit erosion vii. Taxes vili. Inflation ix. The introduction of Yuck by the competitor The reputation of Terrible as an innovator xi. Any other issues 4) An appendix with tables of annual cash flows and the NPV analysis. V. X. Terrible Toys Terrible is an Ontario-based manufacturer of children's toys, and over the years it has pioneered a large number of products that are sold internationally. Some of these turned out to be fads, while others have become permanent fixtures of our popular culture. In both situations, Terrible's management has found ways to turn them into very lucrative opportunities for the company. Competition in the toy market is cut-throat, but by responding quickly and forcefully to competitive threats, Terrible has managed to do more cutting than bleeding. Their aggressiveness in the product markets has always been guided and disciplined by careful analysis, Said one senior executive, "Our big advantage over other companies is that we actually take toys seriously Recently a new threat has emerged. A competitor has introduced a product known as Yuck. It is a slimy miracle substance that will slide off of flat surfaces. When thrown by the handful at older people it sticks to their skin or clothing without staining or otherwise causing permanent physical damage. Yuck appears to the management of Terrible as a serious threat in part because it will erode sales of their own products, Ack and Silly Dough. Further to the extent that this type of product will generate new sales, they are anodious to get in on the action. This is, in many ways, the perfect toy." claims one of the company's analysts, "It brings out the worst in small children with relatively benign consequences for adults. Accordingly, the firm has spent $4 million over the past year developing and test marketing a new product, to be called Icky Goo. Icky Goo will have several advantages over the competitive product. It can be sold in a variety of fluorescent colours, as opposed to the mud brown of Yuck. It can also be scented in foul ways, so that adults will find it even more distasteful and children will therefore find it more amusing. The company plans to sell Icky Goo in Rotten-Egg Yellow, Ol-Spill Purple, Greasy Green, and Sewage Brown. Importantly, Terrible hopes that the introduction of Icky Goo will reinforce their reputation as a leading innovator in toy technology Based on extensive marketing and production analyses, the company has estimated the sales and costs associated with the product over its expected life. The expected future accounting profits are provided in the table below. The table is only intended as guidance - you should adjust any numbers that you think should be adjusted for the purpose of your recommendation. Terrible plans to launch the product with a media blitz that will cost $6 million for each of the first two years. Once the product is established, continuing advertising and promotional expenses will run about $2 million a year. To mass-produce the product, Terrible would have to purchase new equipment immediately at a cost of $32 million. The new equipment would have an expected life of four years, after which it would have to be replaced. It has no salvage value. Assume it is depreciated for tax purposes straight-line over the four years. Marketing Icky Goo would also require warehouse and trucking facilities. Rather than purchasing new facilities, the company would lease them at a rate of $4 million per year. This rate would be contractually fixed for eight years, and payable at the beginning of each year. The introduction of Icky Goo will create a unique problem for the company. To a moderate extent, it will draw sales away from the company's existing products Ack and Silly Dough. Estimates of the profit erosion are shown in the appended table. Because competitors have already introduced similar products, however, Terrible' financial analysts are uncertain how to treat this profit erosion As a matter of policy, Terrible allocates a portion of the company's general and administrative overhead costs to each product line. The addition in allocated overhead to the Inane Toys Division, which will be in charge of Icky Goo, will be $5 million per year, even though the new products would only create $2 million per year in incremental overhead expenses. Estimates of the after-tax profits for the new product line are provided in the table below. The analysis is restricted to 8 years because management feels that this reflects the likely product life for Icky Goo. Given the risks involved, management feels that a 12% nominal discount rate should be used. Inflation is expected to be 3% annually. (For clarity, you are encouraged to present your analysis in nominal terms.) Estimated Future Net Profits For Icky Goo (All figures in millions of dollars) 2021 15.00 2022 20.00 2024 15.00 annually from 2025 to 2028 12.00 Cases Sold Sales Cost of Goods Sold Depreciation Lease payments Advertising Overhead Operating Profit Taxes Net Profit Profit Erosion Adjusted Net Profit 45.00 22.50 8.00 4.00 6.00 5.00 60.00 30.00 8.00 4.00 6.00 5.00 2023 25.00 75.00 37.50 8.00 4.00 2.00 5.00 45.00 22.50 8.00 4.00 2.00 5.00 36.00 18.00 8.00 4.00 2.00 5.00 -0.50 -0.13 -0.37 2.00 -2.37 7.00 1.86 5.14 2.00 3.14 18.50 4.90 13.60 1.00 12.60 3.50 0.93 2.57 0.00 2.57 -1.00 -0.27 -0.74 0.00 -0.74 Cost of Goods Sold is 50% of Sales. Depreciation is computed using the straight-line method, a four-year life, zero salvage value, and based on the cost of the new equipment. Depreciation is always calculated in nominal terms. Terrible pays a combined federal and provincial marginal tax rate of 26.5%. It is now late 2020 you are asked to provide an analysis and a recommendation on whether to introduce Icky Goo. If approved, operations will begin immediately