Question 1 (40 marks) Norman Company has an opportunity to produce and sell a revolutionary new smoke detector for homes, and the project would expect to last for 6 years. To determine whether this would be a profitable venture, the company has gathered the following data on probable costs and market potential: 1. New equipment would have to be acquired to produce the smoke detector. The equipment would cost $600,000 and be usable for 6 years. After 6 years, it would have a resale value at $60,000. Over the 6-year period, annual depreciation would be $90,000. 2. Production and sales of the smoke detector would require a working capital investment of $120,000 to finance account receivable, inventories, and day-to-day cash needs. This working capital will be locked for the whole project duration, and would only be released for use elsewhere after 6 years. 3. An extensive marketing study projects sales in units over the next 6 years as follows: Year 1 2 3 4-6 Sales in Units 8,000 12,000 14,000 18,000 4. The smoke detectors would sell for $60 each, and total variable costs would be $32 per unit. 5. The company is required to advertise heavily during the early years of sales. The advertising program follows: Year 1 2 3 4-6 Annual advertising 120,000 60,000 30,000 20,000 6. Annual fixed costs (excluding depreciation indicated in 1. above) for salaries, insurance etc would totaled $110,000 per year. 7. The equipment would need a major repair at the end of year 4, and would cost $70,000 to do so. 8. The company's required rate of return is 18%. 9. Income tax is ignored for the analysis. Required: 1. How should depreciation and its associated income taxes be treated in capital budgeting analysis? Explain. (4 marks) 2. Compute the net cash inflow (cash receipts less yearly cash operating expenses) anticipated from sale of the smoke detectors for each year over the next 6 years. Initial acquisition of equipment and investment in working capital should be IGNORED in this part. (6 marks) 3. Using the data computed in (2) above and other data provided in the question, determine the net present value of the proposed investment. Would you recommend that Norman Company accept the smoke detector as a new product? (14 marks) 4. Is the project's internal rate of return higher or lower than 18%? (2 marks) 5. For this part, assuming all annual cash flows happen evenly over the years (for simplicity, assuming resale of equipment and release of working capital at the end of year 6 will also be happening evenly over year 6): a. Calculate the payback period for the smoke detector project (4 marks) b. Calculate the discounted payback period for the smoke detector project (6 marks) 6. Discuss the pros and cons of using payback method. (4 marks)
