S998AMMT.8
8.You work for Mattel and you are negotiating with Lucasfilm for the rights to manufacture and sell Star Wars toys. Your marketing department estimates that you can sell $500 million worth of Star Wars toys per year for 3 years, starting next year. They base this estimate on marketing research costing $5 million. These toys will cost you $250 million per year to manufacture (this includes salaries of new managers and employees). Production will require you to immediately increase your working capital from $50 million to $65 million. Working capital will decrease to $50 million again at the end of the third year. You will have to buy new equipment worth $100 million. This equipment will have a useful life of 5 years and will be depreciated to zero using straight-line depreciation over 5 years. You plan to sell the equipment at the end of the third year for $50 million. Mattel’s total current overhead is $20 million per year. If decide to do the project, you will spend $10 million immediately on an advertising campaign. Lucasfilm wants you to pay $250 million (now) for the rights. Your tax rate is 40%. If your cost of capital for this project is 10%, should you accept the offer? (20)
The marketing research is sunk and the current overhead is not incremental (it is incurred even without the project). The sale of the equipment at the end of the 3rd year involves a profit equal to the selling price minus the BV (50-40). That $10 million is taxed at 40%, meaning you pay $4 million on that sale, leaving you with $50-4=46 million. The cash flows from this project look like:
0
1
2
3
Revenues 500
500
500
Expenses -250
-250
-250
Depreciation -20
-20
-20
EBIT 230
230
230
Tax (40%) -92
-92
-92
Net Income 138
138
138
Add Back Depr +20
+20
+20
Capital Investment -100
+46
Cash flows from WC -15
+15
Immediate Advertising -10
Cost of Rights -250
Net Cash Flow -375
+158
+158
+219
Since the NPV is positive, take the offer.