If the management decide to discontinue this product line at the end of 2007, then it can sell the fixed assets related to the product line (having a book value of $7 million) for about $3 million, and the loss of $4 million would be tax deductible. Furthermore, the company can recover the working capital (inventory plus accounts receivable, minus accounts payable and other expenses) worth about $3. 9 million at the end of 2007. Assuming that the appropriate discount rate is 12 percent, would you recommend that this product line be discontinued at the end of 2007 or be continued through 014? 25-Marks) What is the next best alternative open to the company, besides either shutting it down immediately at the end of 1 997 or continuing to run it until 2014? (25-Marks) Q. 2 The company is considering the introduction off new product that IS expected to reach sales of SSL O million in its first full year and $13 million of sales in the second and third years. Thereafter, annual sales are expected to decline to ;o-thirds of peak annual sales in the fourth year, and one-third of peak sales in the fifth year. No more sales are expected after the fifth year.
The cost of goods sold is about 60 percent of the sales revenues in each year. The sales general and administrative (SO&A) expenses are about 23. 5 percent of the sales revenue. Tax on profits is to be paid at a 40 percent rate. The capital investment of $0. 5 million is needed to acquire production equipment. No salvage value is expected at the end of its 5-year useful life. This investment is to be fully depreciated on a straight-line basis over 5 years. In addition, working capital is needed to support the expected sales in an amount equal to 27 percent of the sales revenue.
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This working capital investment must be made at the beginning of each year to build up the needed inventory and implement the planned sales program. Furthermore, during the first year of sales activity, a one-time product introductory expense of $200,000 is incurred. Approximately $1. 0 million had already been spent promoting and test marketing the new product. A) Formulate a multilayer income statement to estimate the cash flows throughout its five-year life cycle. (20-Marks) b) Assuming a 20 percent discount rate, what is the new product’s net present value? (20-Marks) c) Should the company introduce the new product? (10-Marks)