If Mistral decides to enter the computer fan manufacturing business, it must abandon an existing product line that has two more years of expected life with incremental after-tax cash flows of $500,000 in each of those years. If Mistral abandons that product line, those cash flows cannot be recovered in the future. Further, the FINC 6601 Module 04 Assignment Page 2 R&D costs noted above to develop the new manufacturing process have totaled about $150,000, and the marketing research on the specialty/hobby market cost $50,000. The CFO of Mistral, Inc. has asked you, as their financial analyst, to evaluate this new opportunity project and to provide a recommendation on whether to go ahead with the investment that would allow them to enter the computer fan manufacturing business. To simplify the analysis, assume that the initial investment that will occur immediately (i.e., production facilities will immediately be switched to the new product) and all other cash flows will occur at the relevant year-end. Mistral, Inc. must initially invest $1.6 million to purchase new production equipment for the new product. Mistral estimates that they can sell this equipment for $390,000 at the end of the project, 4 years from now. As noted above, Mistral Industries can potentially sell the cooling fans in two distinct markets (the markets are independent, i.e., Mistral will be able to sell either in both markets or only one of them): 1. Under contract: The contract with the major computer maker calls for 45,000 cooling fan units in the first year at $40 per unit. Thereafter, the number of units delivered will increase by 2% per year and the price received by Mistral will increase only by 2% above the rate of inflation each year (see below) until the end of the four-year contract. 2. The specialty/hobbyist market: This retail market has higher margins; Mistral expects to receive a unit price of $60 in this market in the first year. The market research predicts that the size of this entire market will be 90,000 units in the first year and that Mistral can obtain a 15% market share of the market. It is expected that unit sales in this market will grow by 4% per year, and that Mistral will be able to maintain its market share and increase its price by 2% above the inflation rate (see below) each year. The variable cost to produce each unit is $18 in the first year. Since the product in each market is essentially identical (and produced with the same equipment), this unit cost is the same in each market. However it is projected that this cost will increase each year by 3% percent above the inflation rate (see below) each year because of efficiency losses as the production equipment ages. Further, Mistral will incur general, marketing and administrative costs (period costs) of $350,000 the first year regardless of whether they are in one or both markets. These period costs are expected to increase at the inflation rate (see below) in the subsequent years. These general marketing and administrative costs will cover their involvement in either market alone or both markets together. Mistral’s marginal corporate tax rate is 34% percent. Annual inflation is expected to remain constant at 1.5% during the period of the project. The company uses a 12% discount rate to evaluate new investment decisions of this kind. The appropriate depreciation schedule for the equipment is the seven-year MACRS depreciation schedule. This allows the following depreciation schedule for the four years of the project: First year 14.3% Second year 24.5% Third year 17.5% Fourth year 12.5% The immediate initial working capital requirement is $200,000. Thereafter, the net working capital requirements will be 11 percent of sales (i.e., required at the end of each year except the last, when working capital is recovered.) FINC 6601 Module 04 Assignment Page 3 You are asked to provide the following items (and the analysis that leads to them): 1. NPV, IRR, payback period, discounted payback period, and profitability index for this project as described above (i.e., entering both markets as described above). 2. A recommendation about whether Mistral should proceed with this project (i.e., purchase the equipment and enter both markets simultaneously) based on your decision rules. 3. Provide an estimate of the minimum market share that Mistral must achieve in the specialty/hobbyist market for this overall project to have a positive net present value. 4. Provide an estimate of the minimum market share that Mistral would need to achieve a positive net present value if it entered only the specialty/hobbyist market and not the contract with the computer manufacturer.