Rosa Fennicottero Inc. (RF Inc.) is considering the introduction of a new product: Pink Flamingo lawn ornaments.
The design and a prototype of the lawn ornaments were developed at an R&D cost of $2.4 million over the past 3 years. In order to produce the new line of
ornaments RF Inc. would have to acquire a new special-purpose machine at a cost of $2.5 million with another $500000 of installation costs.
Although the economic life of this machine would be ten years (with an expected salvage value of $300000 at the end of the tenth year) it is classified as
7-year MACRS property for income tax purposes. The recovery percentages are 14.29% 24.49% 17.49% 12.49% 8.93% 8.92% 8.93% and 4.46% in years one through
The flamingos produced on the new machine will have to be painted pink. The painting can be accomplished by using an existing but idle painting machine that
is under a noncancelable ten-year lease with rent of $45000 per year. To modify this machine for the purpose of painting the flamingos RF Inc. will have to
spend $50000 immediately which can be expensed immediately for income tax purposes.
RF Inc. expects to sell 12000 pink flamingos the first year with unit sales increasing by one thousand units per year in each subsequent year until the end
of the seventh year. After the seventh year RF Inc. will not be able to produce anymore of the pink flamingos because of an impending federal prohibition of
a component in the pink paint. RF Inc. would then sell the used machine for $250000 since it would have no other uses.
The selling price of the flamingos is expected to be $90 the first year and is expected to increase by four percent annually over the life of the project.
Variable costs are expected to be $25 per unit and are expected to increase at the expected three percent annual rate of inflation. RF Inc. will have to
hire a supervisor to manage the new product line at a salary of $65000 per year including all benefits. The salary and benefits will also increase at the
rate of inflation.
RF Inc. expects that the introduction of the pink flamingos will cannibalize sales of its other lines of lawn ornaments causing a reduction in contribution
margin from these products of $35000 per year. In addition $240000 of working capital will be needed at the outset of the project and will have to be
maintained at that level until the end of the seventh year. At that time RF Inc. will be able to sell the working capital (primarily raw materials
inventory) for 75% of its cost.
RF Inc. is in the marginal 40% income tax bracket (combined state and federal income tax rates). The yield-to-maturity on its debt is 6% per annum the
expected annual return on a risk-free asset is 3% the Beta of its stock is 0.8 and the expected annual return on the market portfolio is 15%. RF Inc. has a
target debt/equity ratio of 1:3 based on book values and 1:4 based on market values.
Required: Support your answers with timelines spreadsheets formulae etc. You may assume that annual recurring cash flows are at
a. What is the payback period for this prospective project? b. What is the discounted payback period for this project? c. What is the
weighted-average cost of capital that RF Inc. should use for capital budgeting?