Introduction The manufacturing company is proposing to launch a new product with the expectancy of selling $950,000 of the new product in the first year and $1,500,000 each year thereafter. They would like a prepared statement showing the incremental cash flows projection over 8 years, an estimated calculation of the payback period and the net present value, and whether or not the project would be accepted with the given estimations.
Cash Flows Statement with 8-year Projection Statement of cash flows “summarizes changes in a company’s cash position, separating operating activities from investment activities and financing activities” (Board, 2014, p. 35). The company will be launching a new product that they are expecting to sell $950,000 in the first year and $1,500,000 each year thereafter. The direct costs, which will include the labor and materials, will be 55% of the sales. They are also expecting the indirect costs to total $80,000 a year. This project may also include a new plant that could cost $1,000,000 with straight line depreciation over the next 5 years,. There will be an additional net investment in inventory and receivables in the amount of $200,000. The firm’s marginal tax rate is 35% with a 10% cost of capital. Table 1 is the cash flow statement to include the revenue, the initial cost of the product at $950,000 and $1,500,000 thereafter for a total of 8 years. Each row forecasts the expectations for the next 8 years. The initial investment, which is the cash outflow, will include the cost of the new plant and the cost of inventory ($1,000,000 + $2300,000). The cost of the inventory of $200,000 will be added back to the cash inflow at the end because the inventory can be sold.
Table 2 and 3 depicts the calculated payback period and the net present value (NPV) for the proposed project. The cost of the plant will be depreciated over 5 years. The payback period is shown to occur between years 2 and 3 in Table 2. “The payback period is the time required for the amount invested in an asset to be repaid by the net cash outflow generated by the asset. It is a simple way to evaluate the risk associated with a proposed project” (Payback Method/Payback Period Formula). The payback time period is 3.3 years. According to the manufacturing company’s payback policy of not accepting projects with life over 3 years, this would not be a project that would be accepted. However, there could be an exception made in this project. There would be no additional investment needed for land and building which would cut cost, this project could be worth pursuing even though it does have a payback period slightly out of the range of the policy.