Question

As a financial analyst, you must evaluate a proposed project to produce printer cartridges. The purchase price of the equipment, including installation, is $65,000, and the equipment will be fully depreciated at t = 0. Annual sales would be 4,000 units at a price of $50 per cartridge, and the project’s life would be 3 years. Current assets would increase by $5,000 and payables by $3,000. At the end of 3 years, the equipment could be sold for $10,000. Variable costs would be 70% of sales revenues, fixed costs would be $30,000 per year, the marginal tax rate is 25%, and the corporate WACC is 11%.

The firm’s project CVs generally range from 1.0 to 1.5. A 3% risk premium is added to the WACC if the initial CV exceeds 1.5, and the WACC is reduced by 0.5% if the CV is 0.75 or less. Then a revised NPV is calculated.

What are the revised values for the NPV?

• NPV Best Case Scenario = $  .
• NPV Base Case Scenario = $  .
• NPV Worst-case Scenario = -$  .
• Expected NPV = $

Answer 1

CV or coefficient of variation is a measure of variation of value from mean. High CV means a high variation in values, similarly low CV means lower variation i.e. more precise values. As best case scenario would be one where the CV is lowest. Similarly a worst case scenario would be one where CV is highest. Higher the CV more the risk premium.

Therefore WACC will be:

Situation	WACC
Best case	10.50%
Base case	11%
Worst case	14%

Year	0	1	2	3	NPV
Annual sale units		4,000.00	4,000.00	4,000.00
Selling price per unit		50.00	50.00	50.00
Total sales (4000*50)		200,000.00	200,000.00	200,000.00
Less: Variable cost (200000*70%)		-140,000.00	-140,000.00	-140,000.00
Less: Fixed cost		-30,000.00	-30,000.00	-30,000.00
Cash flow before tax		30,000.00	30,000.00	30,000.00
Less: Tax @ 25%		-7,500.00	-7,500.00	-7,500.00
Cash flow after tax		22,500.00	22,500.00	22,500.00
Investment	(65,000.00)
Working capital	(2,000.00)
Recovery of working capital (Note 1)				2,000.00
Net cash inflow on disposal of equipment (Note 2)				7,500.00
Total cash flows	(67,000.00)	22,500.00	22,500.00	32,000.00
[email protected]%	1.0000	0.9050	0.8190	0.7412
PV@11%	1.0000	0.9009	0.8116	0.7312
PV@14%	1.0000	0.8772	0.7695	0.6750
[email protected]%	(67,000.00)	20,361.99	18,427.14	23,717.19	(4,493.68)
NPV@11%	(67,000.00)	20,270.27	18,261.50	23,398.12	(5,070.10)
NPV@14%	(67,000.00)	19,736.84	17,313.02	21,599.09	(8,351.05)

Expected NPV = -(4493.68+5070.10+835105)/3 = -5971.61

Note 1: Working capital = Current assets - payables = 5000-3000 = 2000

Note 2: Net cash inlfow on disposal of asset:

Book value of the equipment at the end of 3 years	0
Less: Sales value at thhe end of 3 years	10000
Gain on sale	10000
Less: Tax on gain (10000*25%)	2500
Net cash inflow (10000-2500)	7500