The initial investment is around SR 100 million which is comprised by the building of the factory, the specialized machinery, the office equipment, 2 trucks (SR 185,000 each) to distribute their product to the toys stores across the city, and other minor equipment. The details of the major investment are detailed below:
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The production manager and the construction team estimate that the factory will be set up and fully operational in one year.
The marketing department projects sales of 100,000 units for each product for the first year of the operation, increasing in the following years as indicated below:
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According to their marketing study the following sale prices are adequate to capture the target customers, then the sale price would increase at a fixed rate of +3% which is similar to the inflation expected for the next 10 years.
Electric remote car: SR 175 per unit.
Electric remote helicopter: SR 275 per unit.
4S Robot: SR 375 per unit.
Meanwhile, the finance department considers that the production cost per unit for each one of the products will be as follows:
Electric remote car: 35% of unitary sale price.
Electric remote helicopter: 40% of unitary sale price.
4S Robot: 45% of unitary sale price.
The administration cost is considered as 20% of the total sales revenue of every year.
Toys stores are well known in the market and the competition is fierce, the finance department estimates that 4S should have a credit policy for all its customers’ equivalent to 16 percent of their operating revenue. Meanwhile to respond quickly to demand they will have inventory of raw materials equivalent to 8 percent of its production cost. In addition, they will keep credit with their main suppliers estimated of 16 percent of their production cost.
They should not forget to pay their income taxes of 40%.
Our proud entrepreneurs estimate that an annual opportunity cost of 25% is an acceptable yield for their investment.
Finally, due the substantial drop of the projected sales in Year 10, our investors assumed that they will liquidate the company at the end of that year. The finance department projects a market value at the moment of its liquidation for the factory building of SR 40 million; all the other assets have zero liquidation value.
1) Should they go ahead with this investment based on the NPV result? (assume the straight-line method for depreciation) (27 points)
2) What is the payback of the project? Do you consider it is appropriate to go ahead with the project with the estimate payback? What is the minimum IRR acceptable for this project? (3 points)
3) What happens if the sale volumes for the electric remote car remain flat after the first year of the opening? Should they go ahead with the project anyway based on the new NPV and IRR results? (5 points)
4) What happens if we assume an A/R of 25 percent of the total sales revenue instead of the initial 16 percent? What's the new NPV and IRR, should they accept the project or not? Why the increase on A/R impacts the project’s NPV and IRR in such a way? (6 points)
5) In order to be prudent and avoid the loss of all their savings, our investors developed a “Worst Case Scenario” to evaluate their project. The main assumptions of the Worst Case Scenario are as follows: (all the other variables remain unchanged; assume the straight-line method for depreciation)
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a. What is the Worst case scenario NPV and IRR, should they accept the project? Please interpret the results. (9 points)
Investment
Total
Useful Life
(Years)
Factory Building
40,000,000
25
Machinery
55,000,000
10
Office Equipment
3,000,000
4
Trucks
370,000
4
Other Equipment
1,630,000
4
Total Investment
100,000,000
Year
1
2
3
4
5
6
7
8
9
10
% of sales increase
10%
10%
10%
10%
5%
5%
5%
2%
2%
Annual growth in sales is only 5%(The first 5 years after that sales valume are assumed as original plan)
Initial Investment higher by SR 10,000,000 Invested on the factory building
Production & Admin cost up by 5%
Worst case Scenario Assumptions
Tuleenhb
Case--solvequestion5only.docx
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