New Product Development and Project Evaluation

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The new project considered by XYZ Limited for valuation involves the development of a new product, which is expected to increase the company’s sales over the next five years. This new project is evaluated on the basis of assumptions regarding its net income and net operating cash flows. The valuation of the project is performed by using Net Present Value (NPV). This technique is used because it determines the time value of future cash flows from the new project, which is ignored by other methods.

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It also helps in performing sensitivity analysis. Furthermore, the information provided in this memo includes findings of sensitivity analysis, which alters the expected growth rate of revenue from product sales. Finally, a recommendation is presented about the new project that would assist the board of directors in making its investment decision.

Research and Development Expenses

The company has already spent $1 million on its research and development. This cost is treated as a sunk cost. Therefore, it is not part of the incremental cash flows expected from the project and should not be included in the valuation process.

Key Financial Indicators and Measures

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

Project Life 5 years
Decline in Sales (4 and 5 Years) 30%
Cost of Goods Sold 60% of sales
Selling, General, and Administrative Expenses Increase 3% per year after the first year
Working Capital 20% of each year’s sales
Investment $150 million
Depreciation $30 million
Lease foregone $2 million
Increase in lease receipt 3% per year
Dismantling Costs $2 million
Equipment Sale $10 million
WACC 10%
Tax Rate 30%

Table 1. Key Financial Indicators and Measures.

It is indicated that the project life is five years, and depreciation is calculated by using the prime cost method as follows:

Depreciation = Investment / Useful Life = $150 / 5 = $30 million

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Table 1 also indicates that sales in the fourth and fifth years are expected to fall by 30% based on the previous year. This assumption is highly subjective as the data suggests that there is a high standard deviation of the growth rate to be assumed in these years. Therefore, this is considered in the sensitivity analysis, which determines the NPV of the net project based on different expected growth rates.

Projected Net Income and Operating Cash Flows

The projected net income from the new project over the next five years is calculated in Appendix A to determine its expected cash flows. The project sales are provided in the following table:

($ millions) 1 2 3 4 5
Sales 180.00 180.00 180.00 126.00 88.20

It is indicated that product sales revenue in the next three years will be $180 million. However, it will decline in the last two years of the project life. The cost of sales is 60% of the product sales each year. The expected selling, general and administrative expenses are expected to increase by 3% after the first year and are provided in the following table:

($ millions) 1 2 3 4 5
Selling, general and administrative expenses 12.00 12.36 12.73 13.11 13.51

It is highlighted that the facility to be used for the new project is currently leased at $2 million. The lease amount is expected to increase by 3% in each of the next five years. This is treated as a loss of income and deducted from the company’s operating income as it is related to the new project. It is also indicated that the new project will have an operating loss in the fifth year, which means that there will be no tax paid in that year.

The net income is adjusted by the non-cash depreciation amount to calculate net operating cash flows over the project life. Furthermore, tax-adjusted proceeds from the sale of the equipment are treated as a cash inflow of $7 million in the fifth year. The estimated net operating cash flows of the project over its economic life are provided in the following:

($ millions) 1 2 3 4 5
Net Operating Cash Flows 52.44 52.23 52.02 36.68 31.09

It is indicated that the net operating cash flows of the new project are expected to decline over the next five years. The working capital expenditure at the start of the project is determined by calculating its requirement each year and then totaling them as given in the following table:

($ millions) 1 2 3 4 5 Total
Working Capital (36.00) (36.00) (36.00) (25.20) (17.64) (150.84)

Net Present Value and Sensitivity Analysis

The net cash flows are calculated by deducting the dismantling cost of $2 million and adding back the working capital amount to the operating cash flow in the last year. The following table also indicates that the new project will require $300.84 million to start.

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($ millions) 0 1 2 3 4 5
Net Cash Flows (300.84) 52.44 52.23 52.02 36.68 181.93

The NPV of the project is determined to be -$32.90. It implies that the new project is unlikely to generate a positive outcome for the business based on its current assessment. The company will eventually lose money if the board decides to go ahead with the new product launch (Weygandt, Kimmel, and Kieso, 2018). It is recommended that the company should not invest in this project. However, this is further analysed by conducting a sensitivity analysis in which the expected growth rates of product sales are altered to determine changes in the NPV. The following table summarises the results of the sensitivity analysis:

Base (-30%) -20% -10% 0% 10% 20% 30%
NPV -32.9 -26.16 -18.8 -10.83 -2.23 7% 16.84

The sensitivity analysis also shows that the NPV of the new project would remain negative even if the sales growth rate is 0% in the fourth and fifth years. It asserts that the new project is not financially feasible for the company to pursue, and it should evaluate its estimations and review the outcome of the project again.

Reference List

Banerjee, B. (2017) Financial policy and management accounting. 9th edn. New Delhi: PHI Learning Pvt. Ltd.

Hoffmann, P. S. (2018) Firm value: theory and empirical evidence. London: Intech Open.

Nick Scali Limited (2020) Nick Scali – investor information. Web.

Weygandt, J. J., Kimmel, P. D. and Kieso, D. E. (2018) Managerial accounting: tools for business decision making. 8th edn. Hoboken, NJ: John Wiley & Sons.

Appendix A

1 2 3 4 5
Sales 180.00 180.00 180.00 126.00 88.20
Cost of Goods Sold 108.00 108.00 108.00 75.60 52.92
Selling, general and administrative expenses 12.00 12.36 12.73 13.11 13.51
Depreciation 30.00 30.00 30.00 30.00 30.00
Loss of Income (2.06) (2.12) (2.19) (2.25) (2.32)
Operating Income 32.06 31.76 31.45 9.54 (5.91)
Tax 9.62 9.53 9.44 2.86
Net Income 22.44 22.23 22.02 6.68 (5.91)
Add: Depreciation 30.00 30.00 30.00 30.00 30.00
After-tax Salvage Value 7.00
Net Operating Cash Flows 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
Investment (150.00)
Working Capital (150.84) 150.84
Net Operating Cash Flows 52.44 52.23 52.02 36.68 31.09
Less: Dismantling Cost (2.00)
Net Cash Flows (300.84) 52.44 52.23 52.02 36.68 181.93
Discount Factor 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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