Table of Contents

Expenses for Research and Development Principal Financial Indicators and Metrics Projected Net Income and Operating Cash Flows Reference List

The new project that XYZ Limited is evaluating involves the creation of a new product that is anticipated to improve sales over the next five years. This new undertaking is evaluated based on assumptions regarding its net income and net operating cash flows. Using Net Present Value, the value of the project is determined (NPV). This technique is utilized because it determines the time value of future cash flows from the new project, a factor that is neglected by other methods. Additionally, it facilitates sensitivity analysis. In addition, this memorandum contains the results of a sensitivity analysis that vary the anticipated growth rate of product sales revenue. The report concludes with a suggestion about the new project that will aid the board of directors in making its investment choice.

Expenses for Research and Development

The business has already invested one million dollars in research and development. This expense is considered a sunk cost. Therefore, it is not a component of the predicted incremental cash flows and should not be considered in the valuation process.

Principal Financial Indicators and Metrics

The following table outlines the various forecasting assumptions applied for revenue, cost of sales, selling, general, and administrative expenses, project useful life, depreciation, and cash flows.

5 Year Project Lifespan

Decline in Sales (4 and 5 Years) 30%

Cost of Goods Sold account for 60% of sales

After the first year, selling, general, and administrative expenses increase by 3% per year.

Working Capital equal to 20% of annual sales

Investment $150 million

Depreciation $30 million

Lease foregone $2 million

Increase lease income by 3% annually

Deconstruction Costs $2 million

Equipment Sale $10 million

WACC 10%

Rate of 30%

Principal Financial Indicators and Metrics

The project life is declared to be five years, and depreciation is computed using the prime cost technique as follows:

Depreciation = Investment / Utilizable Life = $150 / 5 = $30,000,000

Table 1 also reveals that sales in the fourth and fifth years are anticipated to decline by 30% compared to the prior year. This assumption is very subjective, as the data indicates that the growth rate to be expected in these years has a high standard deviation. Therefore, this is factored into the sensitivity analysis, which evaluates the net present value (NPV) of the project based on various predicted growth rates.

Net income and operating cash flow projections

The predicted net income from the new project over the next five years is used to calculate its expected cash flows in Appendix A. The project sales are shown in the table below.

($ millions) 1 2 3 4 5

Sales 180.00 180.00 180.00 126.00 88.20

The projected revenue from product sales over the next three years is $180 million. Nonetheless, it will decrease during the final two years of the project's lifespan. Annually, the cost of sales accounts for 60% of product sales. After the first year, it is anticipated that selling, general, and administrative expenses will grow by 3%, as shown in the accompanying table.

($ millions) 1 2 3 4 5

Expenses for marketing, general and administration 12.00 12.36 12.73 13.11 13.51

The fact that the facility for the new project is currently rented for $2 million is noted. It is anticipated that the lease amount will grow by 3% annually during the following five years. As it relates to the new project, this is viewed as a loss of income and subtracted from the company's operating income. In addition, it is projected that the new project will incur an operational deficit in the fifth year, meaning that no taxes will be paid in that year.

To determine net operating cash flows over the life of a project, the net income is modified by the noncash depreciation amount. In addition, the tax-adjusted earnings from the sale of the equipment are considered a $7 million cash inflow in the fifth year. The following table details the expected net operating cash flows of the project over its economic lifetime.

($ millions) 1 2 3 4 5

Operating Cash Flows Net 52.44 52.23 52.02 36.68 31.09

It is projected that the new project's net operating cash flows will decrease over the next five years. The working capital expenditure at the beginning of the project is determined by estimating its annual requirements and then adding them up as shown in the table below.

($ millions) 1 2 3 4 5 Total

Working Capital (36.00) (36.00) (36.00) (36.00) (25.20) (17.64) (150.84)

Present Value and Analysis of Sensitivity

The net cash flows are computed by subtracting the dismantling cost of $2 million from the operating cash flow of the previous year and adding back the working capital amount. The following table also reveals that $300.84 million will be required to initiate the new project.

($ millions) 0 1 2 3 4 5

Cash flow from operations (300.84) 52.44 52.23 52.02 36.68 181.93

The project's NPV is calculated to be -$32.90. It means that, based on the existing assessment, the new project is unlikely to provide a beneficial outcome for the business. If the board agrees to proceed with the new product launch, the company will eventually lose money (Weygandt, Kimmel, and Kieso, 2018). It is advised that the business not invest in this project. Nonetheless, this is analyzed further by doing a sensitivity analysis in which the predicted growth rates of product sales are varied to estimate NPV changes. The following table summarizes the sensitivity analysis results:

Base (-30%) -20% -10% 0% 10% 20% 30%

NPV -32.9 -26.16 -18.8 -10.83 -2.23 7% 16.84

Even if the sales growth rate in the fourth and fifth years is 0%, the NPV of the new project would still be negative, according to the sensitivity analysis. It claims that the new project is unfeasible from a financial standpoint and that the corporation should reevaluate its estimates and the project's result.

Bibliography

Financial policy and management accounting. Ninth edition. New Delhi: PHI Learning Pvt. Ltd., 2017.

P. S. Hoffmann, Firm Value: Theory and Empirical Evidence, 2018. London: Intech Open.

Nick Scali Limited (2020) – Investor information for Nick Scali.

Weygandt, J. J., Kimmel, P. D., and Kieso, D. E. (2018). Managerial accounting: decision-making tools. 8th edn. Hoboken, New Jersey: John Wiley and Sons.

Appendix A

1 2 3 4 5

Sales 180.00 180.00 180.00 126.00 88.20

Price of Products Sold 108.00 108.00 108.00 75.60 52.92

Expenses for marketing, general and administration 12.00 12.36 12.73 13.11 13.51

Depreciation 3,00 3,00 3,00 3,00 3,00 3,00 3,00

Income Loss (2,06) 2,12 (2,19) (2,25) (2.32)

Income from Operations: 32.06 31.76 31.45 9.54 (5.91)

Tax 9.62 9.53 9.44 2.86 –

Gross Profit 22.44 22.23 22.02 6.68 (5.91)

Add: Impairment 30.00 30.00 30.00 30.00 30.00

After-tax Salvage Value

7.00

Operating Cash Flows Net 52.44 52.23 52.02 36.68 31.09

Working Capital (36.00) (36.00) (36.00) (25.20) (17.64)

0 1 2 3 4 5

Investing (150.00)

Working Capital (150.84)

150.84

Operating Cash Flows Net

52.44 52.23 52.02 36.68 31.09

Less: Cost of Dismantling

(2.00)

Cash flow from operations (300.84) 52.44 52.23 52.02 36.68 181.93

Factor of Discount 1.00 0.91 0.83 0.75 0.68 0.62

Present Value (300.84) 47.67 43.17 39.08 25.05 112.97

Net Present Value (32.90)

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