A tennis equipment manufacturer, Racquet Sports is considering the introduction of a new high performance tennis ball,

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Question:

A tennis equipment manufacturer, Racquet Sports is considering the introduction of a new high performance tennis ball, the “Super- Ball”.

To produce the balls the company is planning to invest in a new manufacturing machine that has an estimated life of three years. The machine costs $12 million in year 0 and will be depreciated using the straight-line method over its three-year life. The machine is expected to be sold for $1 million at the end of year 4.

The revenues from the sales of the “super-balls” are expected to be $30 million in years 1, 2, and 3 and the manufacturing costs and selling expenses are estimated to be 50% of the annual sales revenues. The introduction of the “super-balls” are expected to erode the revenues of the company’s or their balls. The cost of erosion is estimated at $2 million of pre-tax income in each of the three years in which “super-balls” are sold. However, it is also estimated that if the company does not introduce the super ball then one year later a competitor will and erosion in years 2 and 3 will occur anyway.

There are no inventory requirements, but the accounts receivable from the sale of super-balls are expected to remain outstanding for 120 days. For simplicity, you can assume a year have 360 days. Net working capital will be fully recovered (ie will become equal to zero) in year 4. You may assume that erosion of the company’s other balls does not have any incremental impact on its working capital.

The firm’s marginal tax rate is 25%. The firm’s WACC is 10% and the cashflow of the project have the same risk characteristics as the cashflows from the company’s existing products.

A) Calculate the incremental cashflows of the project?

B) Show the company undertake the project?

C) Is the Internal Rate of Return (IRR) for this project higher or lower than the required rate of return of the project? Explain your answer initiatively without doing any calculations.