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A Manufacturing Company Is Thinking Of Launching a New Product The Co

A manufacturing company is considering launching a new product. The company forecasts sales of $950,000 in the first year, increasing to $1,500,000 annually thereafter.

Direct costs, including labor and materials, amount to 55% of sales. Indirect incremental costs are estimated at $80,000 per year. The project requires a new plant costing $1,000,000, which will be depreciated straight-line over 5 years.

Additionally, an investment of $1,200,000 in inventory and receivables is necessary. No additional investment in land is required. The company's marginal tax rate is 35%, and its cost of capital is 10%.

Your task is to prepare a statement showing the incremental cash flows over 8 years, calculate the payback period and net present value (NPV), and analyze whether the project should be accepted based on these metrics. Also, discuss how additional investments in land or building would influence your decision.

Paper For Above instruction

Introduction

Deciding whether to launch a new product involves comprehensive financial analysis to evaluate the project's viability. Key financial metrics such as cash flows, payback period, and net present value (NPV) help in assessing investment desirability. This paper presents an analysis based on the provided data for a manufacturing company's proposed product launch, including the calculation of incremental cash flows, payback period, and NPV over an 8-year period.

Incremental Cash Flows Calculation

To determine the project's cash flows, we start by analyzing revenues, costs, taxes, depreciation, and investments. Firstly, annual revenues are projected at $950,000 for the first year and $1,500,000 from year two onward. Since the project extends over 8 years, with steady sales afterward, initial calculations focus on the first-year cash flow, then extend to subsequent years.

Variable costs are 55% of sales: For Year 1, direct costs = 0.55 x $950,000 = $522,500. For subsequent years, direct costs = 0.55 x $1,500,000 = $825,000.

Indirect costs are $80,000 annually. Depreciation expense is calculated over 5 years for the $1,000,000 plant, resulting in $200,000 per year. Since depreciation is a non-cash expense, it affects taxes but not cash flow directly.

Calculations of Earnings Before Taxes (EBT):

Year 1: Revenue = $950,000

Variable costs = $522,500

Indirect costs = $80,000

Depreciation = $200,000

EBT = Revenue - Variable costs - Indirect costs - Depreciation

EBT = $950,000 - $522,500 - $80,000 - $200,000 = $147,500

Tax (35%) of EBT: $147,500 x 0.35 = $51,625

Net income = EBT - Tax = $147,500 - $51,625 = $95,875

Cash flow is calculated by adding back depreciation (non-cash expense):

Year 1 cash flow = Net income + Depreciation = $95,875 + $200,000 = $295,875

For years 2-8, revenues are $1,500,000, with identical cost structures:

Variable costs = $825,000

EBT = $1,500,000 - $825,000 - $80,000 - $200,000 = $395,000

Tax = $395,000 x 0.35 = $138,250

Net income = $395,000 - $138,250 = $256,750

Cash flow = Net income + Depreciation = $256,750 + $200,000 = $456,750

Investments and taxes impact cash flows at initiation and over time:

  • Initial investment: $1,000,000 plant + $1,200,000 working capital (inventory and receivables) totaling $2,200,000.
  • Considering tax impact on working capital recovery at project end (Year 8), assuming full recovery, the cash flow in final year includes this addition.

Depreciation does not affect cash flows directly after the initial investment; however, the initial capital expenditure is a cash outflow in Year 0. The net investment in working capital ($1,200,000) is considered an outflow at Year 0 and inflow upon project conclusion (assumed at Year 8).

Therefore, the net incremental cash flows over the 8 years include:

  • Year 0: -$2,200,000 (initial plant and working capital investment)
  • Years 1-7: Annual cash inflows as calculated (Years 1: $295,875; Years 2-8: $456,750)
  • Year 8: Additional recovery of working capital $1,200,000 plus operating cash flow.

Payback Period Calculation

The payback period is the time it takes for cumulative cash inflows to equal the initial investment ($2,200,000).

Cumulative cash flow after Year 1: $295,875

After Year 2: $295,875 + $456,750 = $752,625

After Year 3: $752,625 + $456,750 = $1,209,375

After Year 4: $1,209,375 + $456,750 = $1,666,125

After Year 5: $1,666,125 + $456,750 = $2,122,875

Thus, the project recovers the initial investment between Year 4 and Year 5. To find the exact point, we interpolate:

Remaining to recover after Year 4: $2,200,000 - $1,666,125 = $533,875

Fraction of Year 5: $533,875 / $456,750 ≈ 1.17

Therefore, the payback period is approximately 4 + 1.17 ≈ 5.17 years.

Net Present Value (NPV) Calculation

NPV combines discounted cash flows over time, considering the cost of capital.

Using a discount rate of 10%, each year's cash flow is discounted as follows:

  • Year 1: $295,875 / (1 + 0.10)^1 ≈ $268,977
  • Years 2-8: $456,750 / (1 + 0.10)^t, where t is the year number

Additionally, in Year 8, we include the recovery of working capital of $1,200,000, discounted back accordingly.

Calculating the present value of all cash inflows and subtracting initial investments yields the project's NPV.

Results and Analysis

The calculated payback period of approximately 5.17 years exceeds the company's policy of not accepting projects with a payback period over 3 years. Despite a positive NPV, this duration indicates that the project does not align with the company's investment criteria, which prefer shorter repayment periods.

Impact of Additional Land and Building Investments

If the project required additional investments in land and buildings, these would increase the initial cash outflows, thereby reducing the project's NPV and extending the payback period further. Such capital costs would diminish cash inflows relative to total expenditures, making acceptance even less favorable within the company's policy framework. If the investments in land and buildings extended the payback period beyond the acceptable threshold of 3 years, the company would likely reject the project based on its capital budgeting policy.

Conclusion

Although the project demonstrates a positive NPV, its payback period exceeds the company's threshold, indicating a less attractive investment from this perspective. The additional investments in land and buildings would likely worsen these metrics, further disqualifying the project under current policies. Ultimately, the decision should balance financial metrics with strategic considerations, but based solely on payback period and NPV, the project would not be recommended.

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