Part 3: Can We Upgrade?
It’s now 2017, and El Cap Climbing Company (ECCC) has continued to grow. One of
ECCC’s major revenue-producing products is a spring-loaded camming device called SLCD, or cams. It’s a device with a small handle (called the “trigger”) and two spring loaded “cams” on an axle. When the trigger is pulled, the cams move together, decreasing the size of the cams. It’s then inserted into a crack or pocket in the rock. When the trigger is released, the cams expand. These cams are used as anchors when “trad” rock climbing.
ECCC currently has one set of cams on the market, and sales have been excellent. The cams are lighter and perform better than their competitors. However, as with any high-performance item, technology changes rapidly, and the cams are now falling behind the competition.
ECCC spent $200,000 to develop a prototype for a new line of cams that has all the features of the existing cams, but are made from an even lighter and stronger 7075-T6 aluminum alloy. The company has spent a further $150,000 for a marketing study to determine the expected sales figures for the cam line.
ECCC can manufacture a set of the new cams for an average of $140 each in variable costs. Fixed costs for the operation are estimated to run an additional $2.1 million per year if the new project is undertaken. The estimated sales volume is 75,000, 85,000, 80,000, 70,000, and 65,000 per year for the next five years, respectively. The unit price of the new cam set will be $240. The necessary equipment can be purchased for $10.5 million and will be depreciated on a seven-year MACRS schedule. It’s believed the value of the equipment in five years will be $1.1 million.
Production of the current cam line is expected to be terminated in two years. If ECCC doesn’t introduce the new line of cams, sales will be 45,000 units and 25,000 units for the next two years, respectively. The price of the cam set is $150, with variable costs of $95 each, and fixed costs of $1.5 million per year. If ECCC does introduce the new cams, sales of the existing product will fall by 10,000 units per year, and the price of the existing sets should be lowered to $120 each. Net working capital for the cams will be 22 percent of sales and will occur with the timing of the cash flows for the year; for example, there’s no initial outlay for NWC, but changes in NWC will occur in Year 1 with the first year’s sales. ECCC has a 30-percent corporate tax rate and a required return of 10 percent. (Note: You can create the solutions in the same Excel spreadsheet that has the data report information. Leah has provided you with a data report in an Excel spreadsheet that contains information to answer the following questions:
1. What’s the payback period of the project?
2. What’s the profitability index of the project?
3. What’s the IRR of the project?
4. What’s the NPV of the project?
5. Should Leah accept the project?
6. If Leah needs to adjust the price of the product, what’s the lowest Leah could make the price of the new cam set and still have a positive NPV project (keeping all other assumptions the same)?