RF, Inc. is considering the introduction of a new product: Pink Flamingo lawn ornaments. The design and a prototype of the lawn ornaments were developed at an R&D cost of $3.6 million over the past five years.
In order to produce the new line of ornaments, RF, Inc., would have to acquire a new special-purpose machine at a cost of $4.5 million, with another $900,000 of installation costs. Although the economic life of this machine would be ten years (with an expected salvage value of $750,000 at the end of the tenth year), it is classified as 7-year MACRS property for income tax purposes.
The recovery percentages are 14.29%, 24.49%, 17.49%, 12.49%, 8.93%, 8.92%, 8.93% and 4.46% in years one through eight, respectively. The flamingos produced on the new machine will have to be painted pink. The painting can be accomplished by using an existing, but idle, painting machine that is under a noncancelable ten-year lease with rent of $100,000 per year.
To modify this machine for the purpose of painting the flamingos, RF, Inc., will have to spend $97,500, which can be expensed immediately for income tax purposes. RF, Inc., expects to sell 22,500 pink flamingos the first year with unit sales increasing by six percent per year in each subsequent year until the end of the seventh year.
After the seventh year RF, Inc., will not be able to produce any more of the pink flamingos because of an impending federal prohibition of a component in the pink paint. RF, Inc., would then sell the used machine for $300,000, since it would have no other uses at RF, Inc.
The selling price of the flamingos is expected to be $132 the first year and is expected to increase by five percent annually over the life of the project. Variable costs are expected to be $33 per unit and are expected to increase at the expected four percent annual rate of inflation. RF, Inc., will have to hire a supervisor to manage the new product line at a salary of $70,000 per year, including all benefits.
The salary, and benefits, will also increase at the rate of inflation. RF, Inc., expects that the introduction of the pink flamingos will cannibalize sales of its other lines of lawn ornaments causing a reduction in contribution margin from these products of 75,000 per year.
In addition, $280,000 of working capital will be needed at the outset of the project and will have to be maintained at that level until the end of the seventh year. At that time, RF, Inc., will be able to sell the working capital (primarily raw materials inventory) for 60% of its cost. RF, Inc., is in the marginal 35% income tax bracket (combined state and federal income tax rates).
The yield-to-maturity on its debt is 10% per annum, the expected annual return on a risk-free asset is 3%, the Beta of its stock is 1.3, and the expected annual return on the market portfolio is 10%. RF, Inc., has a target debt/equity ratio of 1:4 based on book values and 1:7 based on market values.
Required: Support your answers with timelines, spreadsheets, formulae, etc. You may assume that annual, recurring cash flows are at year-end.
a. What is the payback period for this prospective project?
b. What is the discounted payback period for this project?
c. What is the weighted-average cost of capital that RF, Inc., should use for capital budgeting?
d. What is the Net Present Value of this project?
e. What is the Internal Rate of Return of this project?
f. Would you recommend that RF, Inc., proceed with this project? Why or why not?