Reference no: EM133227501

Capital Budgeting Case

You are a senior financial analyst at PALTEL and you are requested to analyse the following project, where all of the dollar figures are in thousands of dollars.

In year 0, the project requires an $11,350 investment in plant and equipment which is depreciated using the straight-line method over seven years and has a salvage value of $1,400 in year 7.

The project is forecast to generate sales of 2,000 units in year 1, rising to 7,400 units in year 5, declining to 1,800 units in year 7.

The inflation rate is forecast to be 2.0% in year 1, rising to 4.0% in year 5, and then levelling off.

The real cost of capital is forecasted to be 11.0% in year 1, rising to 12.2% in year 7. The tax rate is constant at 35%.

Sales revenue per unit is forecasted to be $9.70 in year 1 and then grow with inflation. The variable unit cost for Direct Labour, Materials, Selling Expenses, and overhead are forecasted to be $3.50, $2.00, $1.20, and $0.70, respectively, in year 1 and then grow with inflation.

Cash fixed costs for Lease Payment, Property Taxes, Administration, Advertising, and other cash fixed costs are forecasted to be $2,800, $580, $450, $930, and $520, respectively, in year 1 and then grow with inflation. The project will require working capital in the amount of $0.87 in year 0 for every unit of next year's forecasted sales and this amount will grow with inflation going forward.

You expect to sell the machines at the end of the project life for a gain of 600 dollars.

You are required to estimate the free cash flows for this project for each year using Excel model and to calculate the project's NPV. (Perform linear extrapolation if needed for some variables).

Assume that the product life-cycle of seven years is viewed as a safe bet, but that the scale of demand for the product is highly uncertain. Analyse the sensitivity of the project NPV to the unit sales scale factor and to the cost of capital. (Hint: Use two-way data table).