You are part of a team proposing the development of a new two-bladed doodad

You are part of a team proposing the development of a new two-bladed doodad. The project was begun earlier this year under different management. The product is scheduled for introduction during the first quarter of 2013. Though money has been spent already, the new management is skeptical about the project and is asking a number of questions, among them the basic question of whether to continue this project at all. It has fallen to you to do the financial analysis. It is now the very end of the third quarter of 2011.

The development spending schedule is as follows:

Qtr

$1,000\'s

Q1, 2011

30

Q2, 2011

5

Q3, 2011

25

Q4, 2011

45

Q1, 2012

45

Q2, 2012

15

Q3, 2012

25

Q4, 2012

25

Q1, 2013

15



Marketing did some field research and conducted focus groups earlier this year. They will begin promotional spending before product introduction. The Marketing spending plan for research, introduction and promotion schedule is as follows:

Qtr

$1,000\'s

Q3, 2010

25

Q1, 2011

50

Q3, 2012

25

Q4, 2012

30

Q1, 2013

100

Q2, 2013

80



From Q3, 2013 onward for the life of the product, Marketing will spend 15,000 per quarter in ongoing promotional activities aimed solely at maximizing the sale of twobladed doodads.

In support of the project, Manufacturing expects to spend 25,000 as a down payment on equipment in Q2 of 2012 and a progress payment of 65,000 in Q3. The equipment (including a finishing line) will be received, installed and debugged in Q4 of 2012.

During that quarter, final payment on this equipment (in addition to the progress payments) will be $2,000,000. This will provide adequate capacity for up to 150,000 two-bladed doodads per quarter with one only exception. The dedicated finishing line can handle only 100,000 two-bladed doodads per quarter. A second finishing line would cost $300,000. The good news is that, should the second finishing line be required, it can be purchased, installed and debugged in the quarter before it is needed and no down or progress payments are required.

Based on pent-up demand, sales are expected to start strong and grow rapidly. Sales in Q1 of 2013 (the first quarter of production and sale) are forecast to be 80,000 units.

Thereafter, each quarter\'s sales are expected to exceed the previous quarter\'s by 3%. This is a JIT operation so production volume will be equal to sales volume in any given quarter. (There will be no inventory.) In 2013, each two-bladed doodad will cost us $6.50 to produce and we will sell it for $10.00. At the beginning of each subsequent fiscal year we expect to experience a 3% increase in cost but we plan to more than offset it with a simultaneous 4% price increase.

The sales people sell other things as well and are already on the payroll. They are paid

only a salary (with fringes, of course); there are no commissions, bonuses, etc. Total annual expense for sales salaries, including fringes, is $150,000 per quarter. Another team is working independently on the revolutionary THREE-bladed doodad. This is a major project that will require a lot more development time than the two-bladed doodad. However, it is expected to be a breakthrough product that will totally and instantaneously replace the two-bladed doodad when it is introduced in Q1 of 2016.

Therefore, the last quarter in which we can sell two-bladed doodads is Q4 of 2015. There is no scrap value for the equipment used for the two-bladed doodads nor can it be used for the three-bladed model.

The company\'s hurdle rate has been set at 25%. (You may take the quarterly hurdle rate to be 6.25%)

For simplicity, you may assume all expenses and revenues for a quarter get applied at the end of that quarter. You may ignore the effects of taxation, etc. The expense for equipment (other than the down and progress payments) is incurred at the end of the quarter in which the equipment is received.

As a member of the team analyzing this project to determine whether it should be continued, your assignment is to determine the following:

1. What is the current net present value (NPV) of the two-bladed doodad project at the current annual hurdle rate of 25%?

2. Is this an acceptable project for the company? Why or why not?

3. What is the actual annualized Internal Rate of Return (IRR) from this project?

4. If the company\'s annualized hurdle rate was 30%, would this be an acceptable investment? Why or why not?

5. If a competing, mutually exclusive project (“Project X”) had a net present value of $100,000, which one would we pursue, Project X or our doodad project (all other factors being equal)? Why or why not?

6. You\'ve just discovered an advanced robotic blade sharpener that would increase machinery cost by $500,000. Timing will be the same and the increase would be applied to the final payment. The advantage of this machine is that it would reduce the initial unit cost by $0.50. Initial selling price will remain unchanged. Should you opt for the more expensive sharpener? Why or why not?

7. Someone has suggested that, rather than install the second finishing line, we simply cap production at 100,000 two-bladed doodads.

If we were to do that and avoid the cost of the second finishing line, what would be the NPV and IRR? Should we continue with the plan to install the finishing line? To make sure we communicate, don’t answer “yes” or “no”, answer “Cap production.” or “Buy the finishing line.” Give the reasoning behind your response. (To keep things simple, let’s forget about the advanced sharpener for this part of the problem; compare this only with the base case. Also, ignore non-financial considerations such as the effect that limiting production would have on the customers\' perception of our company.)

8. Again focusing on the base case and ignoring thetime-value of money for this part only, and assuming the product was otherwise acceptable, can the company execute this project if it can make available a total of $2,000,000 to do so? Why or why not?


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