Question
You are the owner of a successful fanny-pack company. your fanny-packs are selling well. So well that you are considering adding a premium fanny-pack to
You are the owner of a successful fanny-pack company. your fanny-packs are selling
well. So well that you are considering adding a premium fanny-pack to your line-up of goods. Your
marketing department estimates that you will be able to sell $5 million worth of the premium fanny-
packs annually. Unfortunately, the team informs you that the premium product will not attract new
fanny-pack customers. Rather, the sales of premium packs will cannibalize your existing sales in a 1-to-1
ratio. For every premium fanny-pack you sell for $50, you sell one fewer regular fanny-pack (which
retails for $20). Luckily, both styles of fanny-pack use the same raw materials in the same quantities, so
the costs of goods sold will remain unchanged, and your inventory requirements will be unaffected. You
plan on selling fanny-packs indefinitely, but don't expect sales to increases year-over-year. Your firm's
effective tax rate is 30%, and your cost of capital is 8.5%
(a) The premium nature of these fanny-packs derives from the intricate sewing techniques which
must be used. The only machines capable of such delicate work are produced only in Italy, and
cost an astounding $20 million. If purchased today, the machine will be working by tomorrow.
Moreover, these machines, while beautiful, are notoriously expensive to maintain. If you buy the
machine, you can expect your annual maintenance costs to increase by $250 thousand. Should
you buy the machine?
(b) Alternatively, you learn that a large purse manufacturer has a machine capable of sewing the
premium fanny-packs, and that manufacturer is willing to construct them for you. The purse
company offers the following deal: You supply them with the necessary inventory of raw goods,
and you pay them $30 for each premium fanny-pack made. The pure manufacturer is responsible
for all maintenance costs associated with their machines. Furthermore, the purse company is
willing to let you pay the $30 three months after the date of the sale. Should you take the deal?
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