Based on past experience, costs of sales for the new product were expected to be 60% of total annual sales revenue during each year of its life cycle. Selling, general, and administrative expenses were expected to be 23.5% of total annual sales. Taxes on profits generated by the new product would be paid at a 40% rate.
To launch the new product, Electronics Unlimited would have to incur immediate cash outlays of two types. First, it would have to invest $500,000 in specialized new production equipment. This capital investment would be fully depreciated on a straight-line basis over the five-year anticipated life cycle of the new product. It was not expected to have any material salvage value at the end of its depreciable life. No further fixed capital expenditures were required after the initial purchase of equipment.
Second, additional investment in net working capital to support sales would have to be made. Electronics Unlimited generally required 27¢ of net working capital to support each dollar of sales. As a practical matter, this buildup would have to be made by the beginning of the sales year in question (or, equivalently, by the end of the previous year). As sales grew, further investments in net working capital ahead of sales would have to be made. As sales diminished, net working capital would be liquidated and cash recovered. At the end of the new product’s life cycle, all remaining net working capital would be liquidated and the cash recovered.
Finally, Electronics Unlimited expected to incur tax-deductible introductory expenses of $200,000 in the first year of the new product’s sales. These costs would not be recurring over the product’s life cycle. Approximately $1.0 million had already been spent developing and test marketing the new product. These expenditures were also one-time expenses that would not be recurring during the new product’s life cycle.
(i) Estimate the new product’s future sales, profits, and cash flows throughout its five-year life cycle.
(ii) Assuming a 20% discount rate, what is the product’s net present value? (Except for changes in net working capital, which must be made before the start of each sales year, you should assume that all cash flows occur at the end of the year in question.) What is its internal rate of return?
(iii) Should Electronics Unlimited introduce the new product?
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