to the Capital Investment Committee (CIC), which was chaired by the Estimating Cash Flow-New Project Analysis The Lawn Robot: Is It Really Worth It? knew well, it was how to come up with useful and unique products in Before being given the go ahead" to go into full-scale production of the Lawn Robot, the design team had to present a detailed feasibility study Vice President of Finance, Bill Burton. As was typical in a major under taking of this type, the proposal had to include detailed cost and revenue estimates with sufficient documentation to substantiate the numbers. 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 hard to develop a prototype of a useful and hopefully highly profitable, "unique product. Last month, the design team unveiled a fully tested, prototype of their latest innovation, a remote controlled lawn mower, the "Lawn Robot." Surveys of retailers and customers conducted by the marketing depart- ment indicated that demand would be excellent, provided the price was lower than a riding lawn mower. The testing and development phases took almost three 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 rave reviews. Full production had not ye started, however, because there had been a change in CEOs, and the new CEO was highly conservative. 44 Having been involved with more than a few of these kinds of proposals before, the head of the design team, Matt Robichek, knew that he had better take every possible factor into consideration and be prepared for a meeting. Luckily for Matt, his assistant, Chris Robinson, who had recently earned his chartered financial analyst (CFA) designation, was an experi- Case 11 45 The Lawn Robot: Is It Really Worth It? enced and dependable employee. Prior to being hired by CPC three years ago, Chris had worked for another large engineering company for over 10 years. "Chris, we have to dot all the 'i's' and cross all the 'is' on this one!" said Matt. "Or else the big guys are going to tear us apart, because we're talking major dollars here. Their main question is going to be, is it really worth it?" So Matt and Chris began collecting the necessary information. They knew that to have a comprehensive feasibility study they would have to include the following: 1. 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 2. Break-even analysis. 3. 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 Lawn Robot over its 10-year economic life and the expected selling price per unit. Note that the price of $1,000 per unit was estimated to gradually drop to $900 per unit over the 10-year period reflecting competitive pressures. Depreciation for this project was based on the seven-year MACRS rates as shown in Table 2. The cost of equipment, including shipping, handling, and instal- lation, was estimated at $20 million. It was estimated that after 10 years, the equipment and tools could be sold for $4 million. The manufacturing would be done in an unused plant of the firm. Similar plant locations could be leased for $10,000 per month. Fixed costs were estimated to be $1,500,000 per year while variable production costs per unit were expected to be $400. To get the project underway, additional inventory of $500,000 would be required. The company would increase its accounts payable by $600,000 and its accounts receivable by $1,000,000. Matt and Chris estimated that each year thereafter, the networking capital of the firm would amount to 5% of sales. The weighted average cost of capital was calculated to be 14%. Interest expenses on debt raised to fund the project were estimated to be $400,000 per year. The company's tax rate was expected to remain constant at 34%. The Lawn Robot: Is It Really Worth It? Case 11 46 Table 1 barn Projected Unit Sales and Price for Lawn Robot Unit Price Unit Sales Year $1000 30,000 1000 Nun DN 34,000 olamo aldebu 1000 38,800 to boulon bed 38,000 brow 950 36,000 0 Mb 950 36.000 Gollob to 9 950 35,500 950 900 blow coi che ild 34,500 dagars 34,000 900 35,000 8 9 900 10 in Los yon emotong Lining boxit 2000 quomodliwy Table 2 Modified ACRS Depreciation Allowances Year 3-Year 5-Year 7-Year 1 2 14.29% 33.33% 44.44 14.82 3 4 7.41 20.00% 32.00 19.20 11.52 11.52 5.76 5 6 7 8 24.49 17,49 12.49 8.93 8.93 8.93 4.45 Case 11 The Lawn Robor: Is It Really Worth It? 47 Questions: 1. Prepare a pro forma statement showing the annual cash flows resulting from the Lawn Robot project. 2. Use a scenario analysis to show how the cash flows would change if the sales forecasts were 15% worse (pessimistic) and 15% better (optimistic) than the stated forecast (base). 3. Realizing that the CIC will demand some kind of sensitivity analyses, how should Matt and Chris prepare their report? Which variables or inputs obviously need to be analyz. ed using multiple values? Explain by performing suitable calculations. 4. How should the annual interest expenses of $400,000 be treated? Explain. 5. Using the base case estimates calculate the cash, accounting, and financial break-even of the Lawn Robot project. Interpret each one. 6. Say the company spent $500,000 in developing the prototype of the Lawn Robot. How should Matt and Chris treat this item in their report? Explain. 7. Calculate the IRR of the project. Based on your calculations what would you recommend? Why? 8. How sensitive is the net present value of the project to the cost of capital? 9. Calculate the operating leverage entailed by this project. What does it indicate? 10. What other types of contingency planning should Matt and Chris include to make the report comprehensive? Please ex- plain the relevance of each suggestion. to the Capital Investment Committee (CIC), which was chaired by the Estimating Cash Flow-New Project Analysis The Lawn Robot: Is It Really Worth It? knew well, it was how to come up with useful and unique products in Before being given the go ahead" to go into full-scale production of the Lawn Robot, the design team had to present a detailed feasibility study Vice President of Finance, Bill Burton. As was typical in a major under taking of this type, the proposal had to include detailed cost and revenue estimates with sufficient documentation to substantiate the numbers. 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 hard to develop a prototype of a useful and hopefully highly profitable, "unique product. Last month, the design team unveiled a fully tested, prototype of their latest innovation, a remote controlled lawn mower, the "Lawn Robot." Surveys of retailers and customers conducted by the marketing depart- ment indicated that demand would be excellent, provided the price was lower than a riding lawn mower. The testing and development phases took almost three 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 rave reviews. Full production had not ye started, however, because there had been a change in CEOs, and the new CEO was highly conservative. 44 Having been involved with more than a few of these kinds of proposals before, the head of the design team, Matt Robichek, knew that he had better take every possible factor into consideration and be prepared for a meeting. Luckily for Matt, his assistant, Chris Robinson, who had recently earned his chartered financial analyst (CFA) designation, was an experi- Case 11 45 The Lawn Robot: Is It Really Worth It? enced and dependable employee. Prior to being hired by CPC three years ago, Chris had worked for another large engineering company for over 10 years. "Chris, we have to dot all the 'i's' and cross all the 'is' on this one!" said Matt. "Or else the big guys are going to tear us apart, because we're talking major dollars here. Their main question is going to be, is it really worth it?" So Matt and Chris began collecting the necessary information. They knew that to have a comprehensive feasibility study they would have to include the following: 1. 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 2. Break-even analysis. 3. 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 Lawn Robot over its 10-year economic life and the expected selling price per unit. Note that the price of $1,000 per unit was estimated to gradually drop to $900 per unit over the 10-year period reflecting competitive pressures. Depreciation for this project was based on the seven-year MACRS rates as shown in Table 2. The cost of equipment, including shipping, handling, and instal- lation, was estimated at $20 million. It was estimated that after 10 years, the equipment and tools could be sold for $4 million. The manufacturing would be done in an unused plant of the firm. Similar plant locations could be leased for $10,000 per month. Fixed costs were estimated to be $1,500,000 per year while variable production costs per unit were expected to be $400. To get the project underway, additional inventory of $500,000 would be required. The company would increase its accounts payable by $600,000 and its accounts receivable by $1,000,000. Matt and Chris estimated that each year thereafter, the networking capital of the firm would amount to 5% of sales. The weighted average cost of capital was calculated to be 14%. Interest expenses on debt raised to fund the project were estimated to be $400,000 per year. The company's tax rate was expected to remain constant at 34%. The Lawn Robot: Is It Really Worth It? Case 11 46 Table 1 barn Projected Unit Sales and Price for Lawn Robot Unit Price Unit Sales Year $1000 30,000 1000 Nun DN 34,000 olamo aldebu 1000 38,800 to boulon bed 38,000 brow 950 36,000 0 Mb 950 36.000 Gollob to 9 950 35,500 950 900 blow coi che ild 34,500 dagars 34,000 900 35,000 8 9 900 10 in Los yon emotong Lining boxit 2000 quomodliwy Table 2 Modified ACRS Depreciation Allowances Year 3-Year 5-Year 7-Year 1 2 14.29% 33.33% 44.44 14.82 3 4 7.41 20.00% 32.00 19.20 11.52 11.52 5.76 5 6 7 8 24.49 17,49 12.49 8.93 8.93 8.93 4.45 Case 11 The Lawn Robor: Is It Really Worth It? 47 Questions: 1. Prepare a pro forma statement showing the annual cash flows resulting from the Lawn Robot project. 2. Use a scenario analysis to show how the cash flows would change if the sales forecasts were 15% worse (pessimistic) and 15% better (optimistic) than the stated forecast (base). 3. Realizing that the CIC will demand some kind of sensitivity analyses, how should Matt and Chris prepare their report? Which variables or inputs obviously need to be analyz. ed using multiple values? Explain by performing suitable calculations. 4. How should the annual interest expenses of $400,000 be treated? Explain. 5. Using the base case estimates calculate the cash, accounting, and financial break-even of the Lawn Robot project. Interpret each one. 6. Say the company spent $500,000 in developing the prototype of the Lawn Robot. How should Matt and Chris treat this item in their report? Explain. 7. Calculate the IRR of the project. Based on your calculations what would you recommend? Why? 8. How sensitive is the net present value of the project to the cost of capital? 9. Calculate the operating leverage entailed by this project. What does it indicate? 10. What other types of contingency planning should Matt and Chris include to make the report comprehensive? Please ex- plain the relevance of each suggestion