Question

PART I:

Suppose a firm is considering the following project (all figures in $ thousands):

To undertake the project the firm will need to make a one-time investment of $137,500 in year 0. This specialized equipment can be depreciated using the straight-line method over the seven years, with a salvage value of $5,600 in year 7.

Your sales and marketing team tell you that they estimate sales of 7,500 units in year 1, rising by roughly 35% per year through year 5, then declining by 45% each year through year 7. They assume the product is dead at that point, with 0 units demanded/sold in year 8.

The inflation rate is forecast to be 1.5% in year 1, rising by a constant to 2.8% in year 5, then leveling off. The firm’s real cost of capital is forecast to be 9.3% in year 1 and projected to increase by 2.5% each year through year 7. The tax rate is estimated to be a level 39%.

Sales revenue per unit is expected to be $15.30 in year 1. Variable cost per unit is estimated at $10.20 in year 1. Cash fixed costs will be $17,940 in year 1. All will grow with inflation.

What is the project NPV under these assumptions?

PART II:

Consider the same problem as above, but modify it as follows:

Direct labor, materials, selling expenses, and other variable costs are forecast to be $5.20, $4.70, $2.30, and $0.80, respectively in year 1 and grow with inflation.

Lease payment, property taxes, administration, advertising, and other cash fixed costs are expected to be $6,100, $1730, $4680, $2,120, and $2730, respectively in year 1 and grow with inflation.

What are the Total Variable Cost per Unit and Total Cash Fixed Costs?

PART III:

Consider the same problem as in Part II. Assume that the product life-cycle of seven years is a reasonable bet, but you are concerned about the real demand for your product. This is a fairly new product, and demand may be more or less than your sales team believes. Further, if this (and other) risky projects take longer than expected, the firm’s cost of capital may increase (because you are a ‘riskier’ borrower to your creditors).

Analyze the sensitivity of your project (NPV) to the unit sales factor and to the cost of capital. Draw some conclusions about the project given your sensitivity analysis. Your boss wants to know whether it’s a go or not, why you think so, and about which assumptions you are most concerned. Please explain.

** This was all the information given

Answer 1

PART 1:

	1	2	3	4	5	6	7
Sales (Units)	7500.000	10125.000	13668.750	18452.813	24911.297	13701.213	7535.667
inflation	0.01500	0.01825	0.02150	0.02475	0.02800	0.02800	0.02800
cost of capital	0.0930	0.1180	0.1430	0.1680	0.1930	0.2180	0.2430
Tax rate	0.39	0.39	0.39	0.39	0.39	0.39	0.39
Sales/unit	15.300	15.579	15.914	16.308	16.765	17.234	17.717
VC/unit	10.200	10.386	10.609	10.872	11.176	11.489	11.811
FC	17940.000	18267.405	18660.154	19121.993	19657.409	20207.816	20773.635
Depriciation	18842.857	18842.857	18842.857	18842.857	18842.857	18842.857	18842.857
Sales (Amount)	114750	157739.6531	217526.9252	300929.4673	417629.9148	236127.9538	133506.7451
VC	76500	105159.7688	145017.9501	200619.6449	278419.9432	157418.6359	89004.49672
TC	94440.000	123427.174	163678.104	219741.638	298077.352	177626.452	109778.132
Profit before tax	1467.143	15469.622	35005.964	62344.972	100709.706	39658.645	4885.756
Profit after tax	894.95723	9436.469649	21353.63794	38030.43318	61432.92052	24191.77324	2980.3113
Salvage Value							5600.000
Taxes due to disposal of asset							2184.000
Incremental Net Cash Flows	19737.814	28279.327	40196.495	56873.290	80275.778	43034.630	25239.168
DCF	18058.384	22624.83691	26918.41559	30558.84828	33218.67474	13180.57468	5505.251186
NPV	12564.986

PART 2:

Year	1	2	3	4	5	6	7
VC/unit	13.000	13.237	13.522	13.857	14.244	14.643	15.053
VC	97500	134027.1563	184826.7991	255691.7043	354848.9472	200631.5947	113437.1037
FC	17360	17676.82	18056.87163	18503.7792	19021.88502	19554.4978	20102.02374

PART 3:

Yes with lesser sales as expected and higher cost of capital, the NPV will reduce. The factor which is most crucial for the project is demand of the product and the cost of the capital.