You are the marketing manager at ACME Products Canada. You have been charged with increasing sales in you division, namely Widgets and other Mythical Products. You are evaluating two options that your staff have presented to you and are trying to decide which option you will choose. The planning horizon for both projects is 10 years.

Option 1 Expand Line of Widgets

The first option is to start manufacturing and selling a new widget that will complement your current line of products.The details of this proposal are as follows:

• Expected sales (units) are 55,000 in the first year, 120,000 in the second year, and 170,000 for the next 8 years.
• The selling price is expected to be $2.50/unit and the cost to manufacture each widget is $1.00.

In order to manufacture the new widgets, you will require an upgrade to existing machinery that will cost $110,000 (you can treat the upgrade as a new piece of equipment for your analysis). The upgrade is expected to last the full ten years or more and should be depreciated using the straight-line method.

You will have to hire two new workers at an average annual cost of $35,000 per employee. Additional marketing costs are expected to be $75,000 per year. The company expects that initial working capital requirements will be $40,000, and these will not change throughout the life of the project.

Option 2 Invest in a New Product

The second option is to develop an entirely new line of products. This new product is called a Bullaballo.It is expected that sales of Bullaballos will be 3,000 units in the first year, 8,000 in year 2, and 15,000 units for the next eight years. The price for each Bullaballo will be initially set at $75/unit but is expected to increase in year 5 to $95/unit for the remaining years.Production costs are $18/unit.

Production of the Bullaballos will require new machinery that costs $1,000,000 with a useful life of ten years (assume straight line depreciation). As the company does not have enough cash to purchase this equipment, the CEO has authorized you to get an equipment loan in order to help pay for this. The loan would be $800,000 for ten years and would require no principal payments during the term. Interest would be 10% and would be payable annually.

Five additional staff would be required for this option at an average cost of $45,000 per person per year.Marketing costs would be $250,000 in the first year and $200,000 for each year after that.

Initial net working capital requirements would be $200,000 with an additional investment in net working capital of $100,000 in year 3.

Requirement

Using the information above, prepare a detailed ten-year pro-forma income statement for each of the options.Assume a tax rate of 22%.For years in which earnings before tax is negative, you can assume that the negative income tax (i.e. 22% of the loss) is added back to EBT to reduce the net loss for the year.

Using the pro-forma income statements, generate a cash forecast for each option and then determine the NPV for each using a 30% discount rate. On the basis of your analysis, recommend one of the options.

Your answer should be in the form of a memo to the CEO (whose name just happens to be John Moscardelli).The memo should briefly outline your recommendation and your methodology (i.e. how you came to your conclusion). You do not need to include all of the assumptions (e.g. price, units sold, etc.) in the memo, as Mr. Moscardelli is already well aware of them.However, you should explain the concept of NPV and what it tells you (Mr. Moscardelli is a marketer but knows nothing about accounting and finance). In other words, you need to explain carefully, in English, why one option is better than the other.