XYZ plc is a small organisation that specialises in providing on-site cleaning services to both commercial and residential customers. XYZ Clean is considering a project that will introduce a new service for a period of five years and then be terminated. The owner of XYZ, JOHN , hired you as the business manager nearly six months ago. In that time, you have proven to be a very valuable employee and JOHN respects your financial knowledge. He has informed you that a marketing research firm has been contracted to conduct a study regarding the feasibility of introducing the new product. The study, which cost $10,000, revealed the following information with regard to expected sales figures:
|
Year
|
Number of Residential Units (at$25 per unit)
|
Number of Commercial Units (at$50 per unit)
|
|
1
|
2,000
|
1,500
|
|
2
|
2,500
|
2,250
|
|
3
|
4,000
|
2,100
|
|
4
|
3,250
|
2,000
|
|
5
|
1,750
|
1,900
|
|
Variable cost per unit
|
$10
|
$25
|
The new service would require the purchase of new equipment, totalling$220,000, which includes shipping and installation charges. The equipment is to be depreciated on a straight-line basis. XYZ is expected to have an additional$5,000 of fixed costs per year if the project is undertaken. John also expects that the net working capital will need to be increased by $5,000 now and will be equal to 10% of the monetary value of sales for years 1 through 4, with all working capital being full recovered at the end of the project (working capital will be zero at end of year 5). John is in the 40% tax bracket.
JOHN believes that he could get a 14% return on his money if it was not placed in this project. He has asked that you analyze the project and provide a recommendation.
Required:
1. Using the financial information presented in the memo above, you need to compute the net incremental cash flows for each period in order to compute an NPV for this project. Note:Round any present value computations to the nearest dollar.
2. Given the lack of knowledge that your boss has regarding capital budgeting decisions, you will need to explain why you used incremental cash flows to analyse the viability of the project as well as how they are computed (i.e., what costs are not included, which costs are included, why they are discounted, etc).
3. Explain the need for the risk analysis regarding the project to your boss. You will need to demonstrate the effect that changes can have on the profitability of the project by re-computing the project analysis to account for a 10% decrease in the sales forecast for commercial sales.