Reference no: EM133073033

Advanced Corporate Finance

Remark: all the dollar value below should be considered "fair (true) market values" - i.e. any prospective buyer/seller would gladly pay them

You are hired to perform a project analysis for your client, a very profitable producer of computer parts. To compensate you for your valuation services, your contract stipulates that the company will pay you a one time - tax deductible! - fee of $50,000 at T=0.

For the next 7 years, the client would be producing special gaming cords. In year 1, the sales will be 100,000 cords. Every year thereafter, the number of cords sold is expected to increase by 7000 per year.

The price per cord is expected to be $18 the first year; and the price is expected to increase 3% per year thereafter. The variable costs (i.e. the material) are expected to be 25% of the revenues every year. In addition, the client is expected to pay fixed costs of $1,200,000 per year.

The project requires initial capital asset investment (at T=0) - a production machine worth $2,240,000. The value of the production machine is to be depreciated straight-line to zero over 14 YEARS (note: even though the project takes only 7 years, it is very well possible that the time of depreciation may be completely different from the maturity of the project.). It is expected that the production machine will be sold after 7 years for the (salvage) price of $1,200,000.

In addition, the project requires the purchase of land worth $4,000,000 to be paid in cash. The land is not to be depreciated and it is not expected to gain or lose value in the next 7 years.

If the project is undertaken, then in year 8 (i.e., the first year after the end of the production), after-tax land cleanup costs of $250,000 are to be paid by your client.

Initial net working capital (NWC) investment is $80,000 (to be paid immediately) and NWC levels are expected to increase by $4,000 throughout the life of the project (that is, every year, the NWC level is supposed to be $4,000 higher than the previous year's level).

The tax rate is 21% and the required rate of return is 10%.

Part 1: If the company decides to undertake the project, what are the annual levels of total free cash flows associated with the projects in years 0,1,2,...8?

What is the NPV of the project?

What is the Internal Rate of Return (IRR) of the project?

Ultimately, should the company undertake this project?

Part 2: Assume a little different scenario -

A local rich donor will donate the land for the project. The contract stipulates that upon completion of the project, the land shall be returned back to that donor (free of charge) by your client.

How much will the NPV of the project change under these new circumstances? Should your client undertake the project in this case? Why or why not?

Part 3: Go back to the original project you analyzed in parts A through D. Consider this scenario: Assume that the other division of your client produces all necessary material for the product under consideration (gaming cords). So, if the other division diverts their material production toward the gaming cord project, NONE of the variable costs (projected to be 25% of revenues) have to be paid in cash. How much will the NPV of the project change under these new circumstances? Should your client undertake the project in this case? Why or why not?

***USE EXCEL***

Assume land is sold at the end.

This problem is tricky. I am not sure if after-tax salvage value needs to be included. Also, watch out for NWC becoming $4,000 higher than previous year's level. Please share your thoughts on everything when finished.