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Calculating cash flows and NPV for launch of new device

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Question 1
PLI produces unusual gifts targeted at wealthy consumers. The company is analyzing the possibility of introducing a new device designed to attach to the collar of a cat or dog. This device emits sonic waves that neutralize airplane engine noise, so that pets traveling with their owners will enjoy a more peaceful ride. PLI believes that developing this project will require up-front capital expenditure of \$10 M. These costs will be depreciated on a straight-line basis for 5 years.
PLI believes that it can sell the product initially for \$250. The selling price will increase to \$260 in years 2 and 3 before falling to \$245 and \$240 in years 4 and 5, respectively. After 5 years the company will withdraw the product from the market and replace it with something else. Variable costs are \$135 per unit. PLI forecasts sales volume of 20,000 units per year, with increase of 25% in year 2, 20% in year 3, 20% in year 4 and 15% in year 5. Offering this product will force PLI to make additional investments in receivables and inventory. Projected end-of-year balances appear in the attached table.

The firm faces a tax rate of 34%. Assume that cash flows arrive at the end of each year, except for the initial \$10 M outlay.

a) Compute the projects cash flows each year.

b) Compute two NPVs one using 10% discount rate and one using 15%.

c) A PLI financial analyst reasons as follows: "With the exception of the initial outlay, the cash flows of this project arrive in more or less a continuous stream rather than at the end of each year. Therefore, by discounting each year's cash flows flow for a full year, we are underestimating the true NPV. A better approximation is to move the discounting 6 months forward - i.e. discount the year-1 cash flow for 6 months, year-2 cash flow for 1.5 years, and so on - this assumption implies that cash flows take place in the middle of the year instead of at the end of the year." Re-compute the NPVs. Does it make any difference? Explain.

Solution Summary

The solution explains how to calculate the NPV and cash flows for the introduction of a new device.

Solution Preview

1. The cash flows are in the attached file. The profits are calculated by subtracting the Variable Cost from the Selling Price and multiplying by the number of units. The number of units is increased as per the % change and the ...

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