Security Manufacturing, Inc. is a producer of surveillance systems. Its current line of surveillance systems are selling excellently. However, in order to cope with the foreseeable competition from other similar products, SM spent $6,000,000 to develop a new line of HD surveillance systems (new model development cost).

The comprehensive 1440p HD surveillance system model can be used very well for any small home or business. As a result of the advanced HD analog technology made up of a4-channel 4K ultra high definition MPX digital video recorder with two 1440p bullet and two 1440p dome weatherproof security cameras, the system can produce videos of remarkable level of clarity and details at the marvelous2560x1440 resolution for live viewing and recording. This new and professional-grade system can also provide users with sharp HD resolution and outstanding night visions of up to 250 feet. The HD MPX DVRcomes with a hard drive size of 5TB and can support a hard drive up to 12TB of video storage. Using the MediaConnect coaxial cables, the MPX system does not only feature HD recording but also facilitates remote viewing and motion notifications.

The company had also spent a further $1,200,000to study the marketability of this new line of HD surveillance systems(marketability studying cost).

SM is able to produce the HD surveillance systems at a variable cost of $70 each. The total fixed costs for the operation are expected to be $9,000,000 per year. SM expects to sell 3,200,000 units, 3,600,000units, 2,600,000 units, 1,800,000 units and 1,000,000 units of the new HD surveillance system model per year over the next five years respectively. The HD surveillance systems will be selling at a price of $140 each. To launch this new line of production, SM needs to invest $32,000,000in equipment which will be depreciated on a seven-year MACRS schedule. The value of the used equipment is expected to be worth $4,000,000 as at the end of the 5 year project life.

SM is planning to stop producing the existing surveillance system model entirely in two years. Should SM not introduce theHD surveillance system, sales per year of the existing surveillance system model will be 1,600,000 units and 1,250,000 units for the next two years respectively. The existing model can be produced at variable costs of $60 each and total fixed costs of $7,500,000 per year. The existing surveillance system modelis selling for $110 each. If SM produces the HD surveillance system model, sales of existing model will be eroded by 960,000 unitsfor next year and 1,062,500units for the year after next. In addition, to promote sales of the existing model alongside with the HD surveillance system model, SM has to reduce the price of the existing model to $80 each. Net working capital for the HD surveillance system project will be 15 percent of sales and will vary with the occurrence of the cash flows. As such, there will be no initial NWC required. The first change in NWC is expected to occur in year 1 according to the sales of the year. SMis currently in the tax bracket of 35 percent and it requires a 18percent returns on all of its projects.The firm alsorequires a payback of 3 years for all projects.

You have just been hired by SM as a financial consultant to advise them on this HD surveillance system project. You are expected to provide answers to the following questions to their management by their next meeting which is scheduled sometime next month.

What is/are the sunk cost(s) for this HD surveillance system 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 SMon how to handle such cost(s).

What are the cash flows of the project for each year?

What is the payback period of the project?

What is the PI (profitability index) of the project?

What is the IRR (internal rate of return) of the project?

What is the NPV (net present value) of the project?

Should the project be accepted based on Payback, PI, IRR and NPV? Briefly explain.