Reference no: EM133158444

Question - Drillmaster has developed a powerful new hand drill that would be used for woodwork and carpentry activities. It would cost $1 million to buy the equipment necessary to manufacture the drills, and it would require net operating working capital equal to 10% of sales. It would take 1 year to buy the required equipment and set up operations, and the project would have a life of 5 years. If the project is undertaken, it must be continued for the entire 5 years.

The firm believes it could sell 1,000 units per year. The drills would sell for $240 per unit, and Webmasters believes that variable costs would amount to $175 per unit. The company's non- variable costs would be $100,000 at Year 1 and would increase with inflation. After the first year the sales price and variable costs will increase at the inflation rate of 3%.

The equipment would be depreciated over a 5-year period, using the straight-line method. The estimated market value of the equipment at the end of the project's 5-year life is $100,000. The tax rate is 25%.

Also, the project's returns are expected to be highly correlated with returns on the firm's other assets.

Its cost of capital is 10% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 and 1.2. Low-risk projects are evaluated with a WACC of 8%, and high-risk projects at 13%.

a) Develop a spreadsheet model and use it to find the project's NPV, IRR, and payback.

b) Conduct sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and the number of units sold. Set these variables' values at 10% and 20% above and below their base-case values. Include a graph in your analysis.

c) Conduct a scenario analysis. Assume that there is a 30% probability that best-case conditions, with the sales price, number of units sold, variable costs per unit, and fixed cost being 20% better than its base-case value. There is a 30% probability of worst-case conditions, with the variables 20% worse than the base value. The base case condition is assumed to have a 40% probability. What would be the project's coefficient of variation NPV?

d) If the project appears to be more or less risky than an average project, find its risk- adjusted NPV, IRR, and payback.

e) On the basis of information in the problem, would you recommend that the project be accepted?