Reference no: EM133114643

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.

For questions 4 through 10 only change those assumptions or variables explicitly addressed by the specific question. Otherwise, all assumptions and variables should be the same as in your answer to question #3. 

4. To the closest penny, what would the initial unit price have to be in order for the project to just break even, that is, to force NPV = $0?

5. What level of annual unit sales would cause the project to just break even? 

6. What level of sales price increase (the price inflation rate) would cause the project to just break even?

7. What is the project's NPV under the following circumstances:

a. Unit sales price and cash operating costs (variable per unit and fixed) increase at the same rate, 3.0% per year?

b. Unit sales price rises by only 2.5%, but unit variable cash operating costs (variable per unit and fixed) increase by 3.0% per year?    

Two separate tabs on the spreadsheet should be used and included to specifically answer each of the above two questions (a & b). Make the necessary changes in the basic spreadsheet used to answer question #3 in order to answer both questions.  

8. Complete a sensitivity analysis considering the following 7 variables: 

• unit sales, 
• unit sales price, 
• unit variable cash operating costs, 
• fixed cash operating costs, 
• salvage value, 
• annual sales price increase (the price inflation rate), 
• annual operating costs increase (this is the inflation rate for both variable costs per unit and fixed costs). This should be treated as just one variable in your analysis.

Company policy mandates that each of the variables be allowed to deviate from the expected or base value by plus and minus 5%, 10%, 15%, 20%, 25% and 30% in such an analysis. Produce 7 tables, one for each of the above variables, showing the results of your sensitivity analysis upon NPV. 

9.a.   What is the "best case" NPV? 

9b. What is the "worst case" NPV? 

A separate tab on the spreadsheet should be used and included to specifically answer each of the above two questions (a & b). Make the necessary changes in the basic spreadsheet used to answer question #3 in order to answer both questions.  

10a. Complete a Monte Carlo Simulation with 2,000 iterations. From the distribution of NPVs produced, compute the expected NPV, standard deviation, coefficient of variation and the probability the NPV is greater than 0. Use the following assumptions to perform the Monte Carlo simulation:

• Annual unit sales quantity is distributed normally with an expected value of 3,500 units and a 95% confidence interval projection of approximately 2,500 to 4,500 units.
• The unit sales price is distributed normally with an expected value of $110,000 and a 95% confidence interval projection of approximately $100,000 to $120,000.
• Unit variable operating cost is distributed normally with an expected value of $85,000 and a 95% confidence interval projection of approximately $80,000 to $90,000.
• Unit sales price inflation rate is distributed normally with an expected value of 3.0% and a 95% confidence interval of approximately 1.0% to 5.0%.
• Cash operating costs (both variable and fixed) inflation rate is distributed normally with an expected value of 2.5% and a 95% confidence interval of approximately 1.5% to 3.5%.
• Salvage value is distributed uniformly with a bottom limit of $5.0 million and a top limit of $15.0 million.

A separate tab on the spreadsheet should be used and included to specifically answer this question. Your spreadsheet should show the 2,000 iterations and the descriptive statistics of the distribution produced by the simulation. Your spreadsheet should also show the basic spreadsheet that was used to answer question #3 adapted to perform and show the results of the Monte Carlo simulation. Descriptive statistics regarding the NPV should include:  Mean (expected value), Median, Maximum value, Minimum Value, Standard Deviation and Coefficient of Variation.

10b. Based upon the results of your Monte Carlo simulation analysis, is this a high risk or a low-risk project? Based upon your answer and CFO Rachel Star past practice, what is the risk-adjusted NPV (not expected NPV, but just a risk-adjusted NPV)?

11. What is your recommendation? Should your company accept or reject this project? Base your answer and discussion upon the expected NPV, IRR, and MIRR, and all the other analysis you performed in answering questions 3 - 10. You should explicitly discuss how each of these answers (to questions #3 to #10) inform and impact your decision to accept or reject this project. Do not make any assumptions that are inconsistent with information provided.