Reference no: EM133110788

If your company decides to go forward with this project, an assembly facility will be located in buildings leased for $1.15 million annually. This lease payment is tax-deductible, paid at the beginning of each year, and has an escalation clause causing the lease payment to increase 1.25% annually over the life of the project. Thus, the lease payment at the beginning of year 1 (at time zero) will be $1.15 million and it will then increase by 1.25% annually thereafter. Equipment for the facility will cost $83.5 million including delivery and installation. Net working capital needs will be $4.2 million immediately to support the facility. Assume at the end of the project's seven-year life the net working capital will not be needed and returned. 

Equipment depreciation will be according to MACRS 5-year asset class (20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76% respectively for years one through six). The equipment is expected to have a salvage value of $10.0 million after 7 years of use.

Your company expects to produce and sell each drone at an initial price of $110,000 per unit. The facility's annual maximum production capacity is expected to be 5,000 units during the 7-year economic life of the facility. The forecast is for actual production and sales to be 3,500 units annually. Fixed cash operating costs (not including depreciation and lease payment) are estimated to be $52.2 million annually and variable cash operating costs are estimated at $85,000 per unit. Your company's federal-plus-state effective tax rate is 40%. Assume that the company is able to take advantage of all tax shields (tax-deductions).

Your task is to analyze this project. You must recommend acceptance or rejection and evaluate the project's acceptability using the net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR) criteria. Your company's weighted average cost of capital (WACC) and thus the project's required rate of return is 15%.

Rachel star, the CFO, wondered whether it would be appropriate to assume neutral inflation equal to the 3.0% expected general rate of inflation, and if not, how sensitive the results would be to alternative assumptions of differential inflation impacts on revenues and costs. Rachel expects these and other questions to be raised when you present your recommendations to the Executive Committee.

In addition to the basic capital budgeting analysis, Rachel would like you to perform a risk analysis on the new capital budgeting project. The project appears to be profitable, but what are the chances that it might nevertheless turn out to be a loser, and how should risk be analyzed and worked into the decision process? 

You met with Isabella Tate of engineering and Tyler Ross from marketing to get a feel for the uncertainties involved in the cash flow estimates. After several sessions, you concluded the greatest uncertainty involved unit sales, variable cash operating costs and salvage value. Unit sales and the variable cost of production could vary widely, and the realized salvage value could be quite different from the estimates.

As estimated by Ross's marketing staff, if product acceptance is "normal" (base case), then sales quantity during the life of the project would be 3,500 units annually. If acceptance is "poor" (worst case), then only 2,500 units would be sold annually during the life of the project; and if consumer response is "strong" (best case), then the sales volume would be 4,500 annually during the life of the project.

As estimated by Tate's engineering staff, the equipment's salvage value at the end of 7 years could be as low as $5.0 million and as high as $15.0 million. If product acceptance is low (worst case), the equipment's salvage value will likely be about $5.0 million. If product acceptance is high (best case), the equipment's salvage value will likely be about $15.0 million. If product acceptance is normal, then salvage value is expected to be $10.0 million.

Other worst case and best case assumptions from Tate's and Ross's staffs include:

The company's Resolutions' Executive Committee requires that all sensitivity analyses consider changes in at least the following variables: unit sales, unit sales price, unit variable cash operating costs, fixed cash operating costs, and salvage value. The lease payment is fixed by contract so there is no reason to include the lease payment in the sensitivity analysis. Company policy also mandates that each of the variables be allowed to deviate from its expected value by plus or minus 5%, 10%, 15%, 20%, 25, and 30% in such an analysis.

In the past, Rachel had scenario analyses performed on proposed capital budgeting projects in order to measure project risk with a coefficient of variation. She is considering the use of Monte Carlo simulations to estimate the coefficient of variation on future projects. From experience, Rachel considers projects with coefficients of variation between 1.00 and 1.50 to be average risk projects. Projects outside this range would have the required rate of return adjusted up by 4% for high-risk projects and 4% down for low-risk projects.

You have been hired to perform the basic capital budgeting analysis and then to introduce the concepts of inflation and risk into the analysis. Rachel plans to include a comprehensive risk analysis. Your task is to help her perform these analyses and to write up a report so she can make a recommendation to the Executive Committee. To help structure your analysis and report, answer the following questions. 

QUESTIONS

1. What is the year 0 net investment outlay on this project?

2. What is the expected nonoperating terminal cash flow on this project in year 7?

3. Estimate the project's operating cash flows. Assume the sales price will increase by a 3.0% annual inflation rate beginning after year 1, and cash operating costs (variable per unit and fixed) will increase by a 2.5% annual inflation rate, also beginning after year 1. Assume no other cash flows (net working capital, or salvage values) are affected by inflation. Of course, lease payments are impacted by inflation but only to the extent of the previously mentioned contractual escalation clause. What is the project's NPV, IRR, MIRR? Use 15% for the required rate of return.