You just started a new job with the well-known Rochester-based watchmaker RO-lex. Given your solid background in the principles of finance management, you have been asked to value the investment project ‹Grande Complication›. You have the following information about the project: 

• To guarantee exclusivity, production is limited to 40 watches per year.
• To develop ‹Grande Complication›, Ro-lex has already invested $3 million into research and development over the past 2 years. Half of that amount has been paid already; the remaining payment will become due at the end of year 1.
• In the first year, the watch will be sold for $400,000 apiece. The unit price will be raised to $450,000 thereafter.
• The cost of raw materials amounts to 50 percent of revenues. Since the watch is hand-made, labor costs will equal 32 percent of revenues. According to projections, selling and distribution expenses will equal $1.8 million during the first year and $1.2 million thereafter.
• To produce ‹Grande Complication›, RO-lex needs to rent additional space from an independent property owner. These premises are currently unused, and the associated annual rent will be $300,000.
• ‹Grande Complication› will be allocated $500,000 of the firm's overhead.
• The launch of ‹Grande Complication› is likely to bolster the image of the firm and of its other products. The firm is therefore expecting an increase in the earnings before taxes generated by these products. This effect equals 4 percent of the annual sales of ‹Grande Complication›.
• Because of the high degree of technical complexity of ‹Grande Complication›, RO-lex needs to invest $6.0 million into new equipment at the beginning of the first year (today). This investment will be depreciated linearly over 10 years.
• With the launch of the project (today), also the firm's net working capital will increase by $2.0 million. This additional net working capital will gradually be used up, so that it declines by $200,000 per year over the next 10 years.
• The discount rate for the project equals 16 percent per year and the tax rate is 25 percent of taxable income.
• Except for the initial investment into equipment and net working capital, all relevant cash flows occur at year-end. 

Assume it is now the beginning of the first year. 

Carefully answer the following questions:

1. Calculate the project's net cash flows for years 1 and 2.
2. Compute the project's NPV under the assumption that the annual net cash flow will remain constant after year 2 and that the project will run until the end of year 10. Should you continue the project ‹Grande Complication›?
3. Was it a good idea to launch ‹Grande Complication› in the first place?

Answer rating: 100% (QA)

To calculate the net cash flows for years 1 and 2 we need to consider the relevant cash inflows and outflows Year 1 Cash inflows 40 watches 400000 per watch 16000000 Cash outflows Research and develop... View the full answer