Question
In: Accounting
A manufacturer is planning to produce and sell a new product. It would cost $20 million...
A manufacturer is planning to produce and sell a new product. It would cost $20 million at Year 0 to buy the equipment necessary to manufacture the product. The project would require net working capital at the beginning of each year in an amount equal to 15% of the year's projected sales; for example, NWC0 = 15%(Sales1). The product would sell for $30 per unit, and believes that variable costs would amount to $15 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 3%. The project's fixed costs would be $500,000/year in Year 1 and would increase with inflation.
The products will be sold for 4 years. If the project is undertaken, it must be continued for the entire 4 years. The firm believes it could sell 500,000 units per year
The equipment would be depreciated over using straight-line depreciation. The estimated market value of the equipment at the end of the project’s 4-year life is $500,000. The federal-plus-state tax rate is 40%. Its cost of capital is 10%.
Do parts a-e in Excel with separate tabs for each part.
a.) Develop a spreadsheet model, and use it to find the project’s NPV, IRR, and payback. .
- Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and number of units sold. Set these variables’ values at least 5%, 10%, and 20% above and below their base-case values. Include a graph in your analysis. To which variable does NPV appear most sensitive? (Suggestions: Use Excel’s Data Table feature, or re-calculate the NPV of each input level and then copy and paste the results).
- Now conduct a scenario analysis. Assume that there is a 25% probability that best-case conditions, with each of the variables discussed in Part b being 20% better than its base-case value, will occur. There is a 25% probability of worst-case conditions, with the variables 20% worse than base, and a 50% probability of base-case conditions. (Suppose the average CV of this company's projects is 2.0. Is this project more or less risky than the average project for this company?).
- Set up your own numerical example of a real option. You can choose either a timing or an abandonment option. Use any probabilities and cash flows that make sense.
Solutions
Expert Solution
| NPV Method | |||||||||||||
| a. | Computation of Cash Inflow per annum | ||||||||||||
| Year | Sales | Less:Working Capital | Less:Variable Cost | Less: Depreciation | Less:Fixed Costs | Profit | Tax | Profit after Tax | Add:Depreciation | Cash Inflows | Discouning Factor@10% | PV | |
| 1 | 1,50,00,000.00 | 22,50,000.00 | 75,00,000.00 | 48,75,000.00 | 5,00,000.00 | -1,25,000.00 | - | -1,25,000.00 | 48,75,000.00 | 47,50,000.00 | 0.909 | 43,17,750.00 | |
| 2 | 1,54,50,000.00 | 23,17,500.00 | 77,25,000.00 | 48,75,000.00 | 5,00,000.00 | 32,500.00 | 13,000.00 | 19,500.00 | 48,75,000.00 | 48,94,500.00 | 0.826 | 40,42,857.00 | |
| 3 | 1,59,13,500.00 | 23,87,025.00 | 79,56,750.00 | 48,75,000.00 | 5,00,000.00 | 1,94,725.00 | 77,890.00 | 1,16,835.00 | 48,75,000.00 | 49,91,835.00 | 0.751 | 37,48,868.09 | |
| 4 | 1,63,90,905.00 | 24,58,635.75 | 81,95,452.50 | 48,75,000.00 | 5,00,000.00 | 3,61,816.75 | 1,44,726.70 | 2,17,090.05 | 48,75,000.00 | 50,92,090.05 | 0.683 | 34,77,897.50 | |
| 5 | 1,68,82,632.15 | 25,32,394.82 | 84,41,316.08 | 48,75,000.00 | 5,00,000.00 | 5,33,921.25 | 2,13,568.50 | 3,20,352.75 | 48,75,000.00 | 51,95,352.75 | Total PV | 1,55,87,372.59 | |
| The fifth year information is for payback period computation only,not for NPV computation | Less:Initial Investment | 2,00,00,000.00 | |||||||||||
| Add:Salvage Value of Initial Investment(Yr4,10%) | 3,41,500.00 | ||||||||||||
| NPV(4,10%) | -40,71,127.41 | ||||||||||||
| IRR Method | |||||||||||||
| For finding IRR,we assume discount rate to be 7% | Since the Discounting rate 7% is much away from 0 we choose the Discounting rate to be 1% | Even at 1% the NPV is negative | |||||||||||
| We will start from Cash Inflows of above table again | On subsituiting in formula:- | ||||||||||||
| Cash Inflows | DF @ 7% | PV | Cash Inflows | DF @ 1% | PV | LR+ (NPV at LR/NPV at LR-NPV at HR)*(HR-LR) | |||||||
| 47,50,000 | 0.935 | 44,41,250.00 | 47,50,000.00 | 0.990 | 47,02,500.00 | ||||||||
| 48,94,500 | 0.873 | 42,72,898.50 | 48,94,500.00 | 0.980 | 47,96,610.00 | 1%+(-279819.68/-279819.68+2945749.43)*(7-1) | |||||||
| 49,91,835 | 0.816 | 40,73,337.36 | 49,91,835.00 | 0.971 | 48,47,071.79 | ||||||||
| 50,92,090 | 0.763 | 38,85,264.71 | 50,92,090.05 | 0.961 | 48,93,498.54 | IRR | 0.37% | ||||||
| Total PV | 1,66,72,750.57 | Total PV | 1,92,39,680.32 | ||||||||||
| Less:Initial Investment | 2,00,00,000.00 | Less: Initial Investment | 2,00,00,000.00 | ||||||||||
| Add:Salvage Value of Initial Investment(Yr4,7%) | 3,81,500.00 | Add:Salvage Value of Initial Investment(Yr4,1%) | 4,80,500.00 | ||||||||||
| NPV(4,7%) | -29,45,749.43 | NPV(4,1%) | -2,79,819.68 | ||||||||||
| Payback period(Simple,not discounted rate since not mentioned) | |||||||||||||
| Year | Cash Inflow | Cumulative Cash Inflow | |||||||||||
| 1 | 47,50,000.00 | 47,50,000.00 | |||||||||||
| 2 | 48,94,500.00 | 96,44,500.00 |
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