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 had 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 "remote-controlled" 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 the 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 IPI three years ago, Ron had worked for another large engineering company for over 10 years. "Ron, we have to dot 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: 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; Break-Even Analysis; 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 9-year economic life and the expected selling price per unit. Note that the price of $980 per unit was estimated to gradually decrease to $900 per unit over the project period due to competition. Depreciation for this project was based on the 7-year MACRS rates as shown in Table 2. The cost of project, including equipment, shipping, handling, and installation, was estimated at $9.2 million. It was estimated that after the project is over, the equipment and tools could be sold for $1.5 million. The manufacturing would be done in an unused plant of the firm, which could be leased out for $19,000 per month if the firm decided against the lazy mower project. Fixed costs were estimated to be $1,600,000 per year while variable production costs per unit were expected to be $510 per unit. Both the fixed costs and the variable costs are expected to increase at a 2% annual inflation rate. To get the project under way, the company expects $400,000 of the net working capital initially. The net working capital, then, would amount to 4% of sales expected next year for the rest of the project. The weighted average cost of capital was calculated to be 13%. Interest expenses on debt raised to fund the project were estimated to be $600,000 per year. The companys tax rate was expected to remain constant at 26%. Table 1. Projected Unit Sales and Price for Lazy Mower Year Unit Sales Unit Price 1 9,000 980 2 10,000 980 3 11,000 970 4 12,000 970 5 13,000 950 6 14,500 950 7 14,000 930 8 14,000 930 9 13,000 900 Year Modified ACRS Depreciation Allowance 1 33.33% 20.00% 14.29% 2 44.44% 32.00% 24.49% 3 14.82% 19.20% 17.49% 4 7.41% 11.52% 12.49% 5 11.52% 8.93% 6 5.76% 8.93% 7 8.93% 8 4.45% Requirements: 1. On a worksheet labeled Base, prepare a Pro Forma Statement showing the annual cash flows resulting from the Lazy Mower project. Perform capital budgeting analysis with the projected cash flows to compute NPV, IRR, MIRR, and payback. Based on the results, what should Dan and Ron recommend? Be sure to make your interpretation of each computed result in your own wordsn 2. On a separate worksheet labeled Scenario Analysis, create a pro forma statement to show how the cash flows would change if the unit sales forecasts were better or worse than the stated forecast (base). Use Forecast error cell as discussed in class. Using Scenario Manager, create three scenarios (Best, average, and Worst scenario), where the best scenario is for 20% positive sales forecast error with $380 variable cost, and the worst for -20% forecast error with $480 variable cost. Create Scenario Summary (on a separate worksheet) to show how the NPV and IRR change under these scenario. Please use names, rather than cell references, for each variable. 3. How sensitive is the Net Present Value of the project to the sales forecasts (-25% to +25% of the base by 5% increment), and to the variable costs ($410 to $610 by $20 increment)? You must use the Data Table feature in Excel. Find also how bad the sales must be to have zero NPV (goal seek). 4. IPI, Inc. plans to borrow about $6 million to help fund this project at 10% rate. How should the annual interest expenses of $600,000 be treated? Explain. Also note that the company had spent $800,000 in developing the prototype of the Lazy Mower and its related patent. Unless the company takes on the project, the patent can be licensed out for $70,000 a year. How should Dan and Ron treat these items in their capital budgeting analysis? If any of these costs is relevant to the capital budgeting analysis, how does it change the NPV? 5. Using the base case estimates calculate the cash, accounting, and financial breakeven of the Lazy Mower project. Interpret each one. For cash and accounting breakeven, use the first year only. For financial breakeven, assume a constant annual sales each year; so that you are computing the annual sales unit that would make the NPV of the project equal to zero. Additional definitions: Accounting Break-Even = (Fixed Cost + Depreciation) / (Price Variable Cost) Cash Break-Even = (Fixed Cost + other opportunity cost) / (Price-Variable Cost)** **Any opportunity costs that are fixed over the life of the project, and they should be included in the Cash BE formula above, because they do have actual cash flow effects although accounting rules do not recognize them as costs. Financial Break-Even is the level of constant annual sales that results in a zero NPV, assuming a constant annual sales in units.