CHRONOS S.A promising smart watch maker, is thinking of Launching a new Smart Watch (iChronos) in the Global Market : Management Accounting Coursework, NUS, Singapore

Capital Appraisal Techniques

CHRONOS S.A., a promising smart watch maker, is thinking of launching a new smart watch (iChronos) in the global market. The i-Chronos is expected to produce sales of €10 million in the first year and €13 million in the second year. The intense industry competition and price erosion will affect the sales of the smart watch. Sales are initially expected to remain unchanged for the second and third year following introduction, but in the fourth and fifth year, CHRONOS S.A. expects annual sales of the smart watch to fall to two-thirds and one-third of peak annual sales respectively.

After the fifth year, the company is not expecting any sales, costs or expenses associated with the new smart watch. The cost of sales for the new smart watch is expected to reach 60% of total annual sales during each year of its life cycle. Selling and general expenses are expected to be 23.5% of total annual sales and the profit tax rate 40%.

The launching of the new smart watch would require an investment of €500,000 immediately, in new specialised production line, to ensure that the facilities at CHRONOS S.A. are among the most modern in the country. This outlay would be fully depreciated on a straight-line basis over the five-year life cycle of the smart watch, and would not be expected to have any material salvage value at the end of its depreciable life.

Furthermore, CHRONOS S.A. would have to incur an increase in net working capital in order to support sales. The company generally requires 27 cents of net working capital to support each euro of sales. In order to ensure the smooth running of the investment project, the new working capital build-up would have to be made by the end of the previous year. It should be stressed that, as sales grow, further investments in the working capital ahead of sales would have to be made, whereas, as sales diminish, net working capital would be liquidated and cash recovered.

At the end of the smart watches’ life cycle, all remaining net working capital would be liquidated and the cash recovered. CHRONOS S.A. expected, only in the first year of the new smart watch sales, to incur introductory expenses of €200,000. During the development stage of the new smart watch, €1 million will have already been spent. These investments in research and development would also be onetime expenses that would not be recurring during the new products life cycle. Using this information, you are required to:

Question 1

Calculate the product’s cash flows throughout its five-year life cycle and its net present value at 20% discount rate. Calculate also the Internal Rate of Return (IRR). Should the company introduce the new watch? Discuss.

Question 2

The Net Present Value and the IRR have been suggested as the main investment appraisal tools. Critically compare the two methodologies.