Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $20 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that 40% will come from customers who switch to the new, healthier pizza instead of buying the original version.
Assume customers will spend the same amount on either version. What level of incremental sales is associated with introducing the new pizza?
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Suppose that 50% of the customers who will switch from Pisa Pizza’s original pizza to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. What level of incremental sales is associated with introducing the new pizza in this case?
Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the Mini Mochi Munch. Kokomochi plans to spend $5 million on TV, radio, and print advertising this year for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $9 million this year and by $7 million next year. In addition, the company expects that new consumers who try the Mini Mochi Munch will be more likely to try Kokomochi’s other products. As a result, sales of other products are expected to rise by $2 million each year. Kokomochi’s gross profit margin for the Mini Mochi Munch is 35%, and its gross profit mar- gin averages 25% for all other products. The company’s marginal corporate tax rate is 35% both this year and next year. What are the incremental earnings associated with the advertising campaign?
| Year 1 | Year 2 | |
| Incremental Earnings Forecast ($000s) | ||
| Sales of Mini Mochi Munch | 9,000 | 7,000 |
| Other Sales | 2,000 | 2,000 |
| Cost of Goods Sold | (7,350) | (6,050) |
| Gross Profit | 3,650 | 2,950 |
| Selling, General & Admin | (5,000) | - |
| Depreciation | - | - |
| EBIT | (1,350) | 2,950 |
| Income Tax at 35% | 473 | (1,033) |
| Unlevered Net Income | (878) | 1,918 |
Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent $10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store. Which of the following should be included as part of the incremental earnings for the proposed new retail store?
The cost of the land where the store will be located - No, this will not be included directly because it is a sunk cost.
The cost of demolishing the abandoned warehouse and clearing the lot - Yes, this is a cost of opening the new store .
The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead - Yes, this a loss of sales at the existing store, and it should be deducted from the sales at the new store so as to determine the overall incremental increase in sales that Home Builder Supply will generate on opening the new store.
The $10,000 in market research spent to evaluate customer demand - No, this is a sunk cost.
Construction costs for the new store - This is a capital expenditure that is associated with the opening of the new store. For this reason, these costs will increase the company’s depreciation expenses.
The value of the land if sold. - Yes, it should be included as part of incremental earnings so as to cater for opportunity costs.
Interest expense on the debt borrowed to pay the construction costs – No, this item should not be counted as part of the incremental earnings because the project is evaluated separately from its financing decisions.
Hyperion, Inc. currently sells its latest high-speed color printer, the Hyper 500, for $350. It plans to lower the price to $300 next year. Its cost of goods sold for the Hyper 500 is $200 per unit, and this year’s sales are expected to be 20,000 units.
Suppose that if Hyperion drops the price to $300 immediately, it can increase this year’s sales by 25% to 25,000 units. What would be the incremental impact on this year’s EBIT of such a price drop?
Suppose that for each printer sold, Hyperion expects additional sales of $75 per year on ink cartridges for the next three years, and Hyperion has a gross profit margin of 70% on ink cartridges. What is the incremental impact on EBIT for the next three years of a price drop this year?
10. You are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into your office, drops a consultant’s report on your desk, and complains, “We owe these consultants $1 million for this report, and I am not sure their analysis makes sense. Before we spend the $25 million on new equipment needed for this project, look it over and give me your opinion.” You open the report and find the following estimates (in thousands of dollars):
All of the estimates in the report seem correct. You note that the consultants used straight-line depreciation for the new equipment that will be purchased today (year 0), which is what the accounting department recommended. The report concludes that because the project will increase earnings by $4.875 million per year for 10 years, the project is worth $48.75 million. You think back to your halcyon days in finance class and realize there is more work to be done!
First, you note that the consultants have not factored in the fact that the project will require $10 million in working capital upfront (year 0), which will be fully recovered in year 10. Next, you see they have attributed $2 million of selling, general and administrative expenses to the project, but you know that $1 million of this amount is overhead that will be incurred even if the project is not accepted. Finally, you know that accounting earnings are not the right thing to focus on!
Given the available information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed project?
| 0 | 1 | 2 | … | 9 | 10 | |
| =Net Income | 4,875 | 4,875 | 4,875 | 4,875 | ||
| +Overhead (after tax at 35%) | 650 | 650 | 650 | 650 | ||
| +Depreciation | 2,500 | 2,500 | 2,500 | 2,500 | ||
| -Capex | 25,000 | |||||
| -Inc. in NWC | 10,000 | -10,000 | ||||
| FCF | -35,000 | 8,025 | 8,025 | … | 8,025 | 18,025 |
If the cost of capital for this project is 14%, what is your estimate of the value of the new project?
