Accept or reject a new product line
Based on the decision criteria below, should the proposed project be accepted or rejected? Why or why not? As accountants, you must do a Net present Value analysis, and make a recommendation to management.
Ziegler Automotive Concepts Inc. has just developed a new device that will double the gas mileage of any automobile that it is installed on. This device can be mounted on any automobile in a few minutes time for a negligible cost.
The company is anxious to begin production of the new device. To this end, marketing and cost studies have been made to determine probable costs and market potential. These studies have provided the following information:
A. New equipment would have to be acquired in order to produce the device. The equipment would cost $315,000 and have a 12-year useful life. After 12 years the equipment will have a salvage value of $15,000.
B. Sales for the next 12 years are projected as follows:
Year Sales in units
1 6,000
2 12,000
3 15,000
4-12 18,000
C. Production and sales of the device would require working capital of $60,000 in order to finance accounts receivable, inventories, and day-to-day cash needs. This working capital would be released at the end of the 12 year period if it is not needed.
D. The devices would sell for $35 each. Variable costs of production, administration and sales would be $15 per unit.
E. Fixed costs for salaries, maintenance, property taxes, and insurance would total $135,000 per year. Depreciation of the equipment will be calculated using the straight-line method.
F. In order to gain rapid entry into the market, the company will have to advertise heavily. The advertising program would be:
Years 1 & 2 $180,000 per year
Year 3 150,000 per year
Years 4-12 120,000 per year
G. Ziegler Automotive concepts Board of Directors has specified that all of the new product lines must earn at least a 10% return in order to be acceptable.
Required: (label each answer prominently and ignore income taxes)
1. Compute the net cash inflow (cash receipts less yearly cash operating expenses) anticipated from the sale of the device for each of the next 12 years.
2. Using the data from 1 above and other data in the problem, determine the Net Present Value (NPV) of the project for interest factors of 10%, 12%, and 14%. Use the Present Value tables in Appendix A of the textbook.
3. Compute the Internal Rate of Return (IRR) using interpolation.
4. State clearly for management’s benefit whether you as the corporate accountant recommend acceptance or rejection of this project and the reason why or why not.