Let’s consider a hypothetical capital budgeting decision faced by managers of the Linksys division of Cisco Systems, a maker of consumer networking hardware. Linksys is considering the development of a wireless home networking appliance, called HomeNet, that will provide both the hardware and the software necessary to run an entire home from any Internet connection. In addition to connecting PCs and printers, HomeNat will control new Internet-capable stereos, digital video recorders, heating and air-conditioning units, major appliances, telephone and security systems, office equipment, and so on.
HomeNet’s target market is upscale residential “smart” homes and home offices. Based on ...view middle of the document...
The cost of a software engineer (including benefits and related costs) is $200 000 per year.
To verify the compatibility of new consumer Internet-ready appliances with the HomeNet system as they become available, Linksys must also build a new lab for testing purposes. This lab will occupy existing facilities (will be hosted in warehouse space that the company would have otherwise rented out for $200 000 per year during years 1-4) but will require $7,5 million of new equipment. In addition to the new equipment, some equipment will be transferred to the lab from another Linksys facility. The equipment has a resale value of $2 million and a book value of $1 million. The book value can be depreciated next year. When the lab is shout down in year five, the equipment will have a salvage value of $800000.
The software and hardware design will be completed, and the lab will be operational, at the end of one year. At that time, HomeNet will be ready to ship. Linksys expects to spend $2,8 million per year on marketing and support for this product.
HomeNet will have no incremental cash or inventory requirements (products will be shipped directly from the contract manufacturer to costumers). However, receivables related to HomeNet are expected to account for 15% of annual sales, and payables are expected to be 15% of the annual cost of sold goods.
Cisco’s managers believe that the HomeNet project will have similar risk to other projects within Cisco’s Linksys division, and that the appropriate cost of capital for these projects is 12%.
I. Forecasting Earnings
Given the revenue and the cost estimates, we can forecast HomeNet’s incremental earnings, as shown in the table below.
HomeNet’s Incremental Earnings Forecast ($ millions)
| |0 |1 |2 |3 |4 |5 |
|Incremental Earnings Forecast | | | | | | |
|Sales |- |23,5 |23,5 |23,5 |23,5 |- |
|Cost of Goods Sold |- |- 9,5 |- 9,5 |- 9,5 |- 9,5 |- |
|Selling, General, Administrative |- |- 3 |- 3 |- 3 |- 3 |- |
|Research and Development |- 15 |- |- |- |- |- |
|Depreciation |- |- 2,5 |- 1,5 |- 1,5 |- 1,5 |- 1,5 |
|Salvage Value of the Equipment | | | | | ...