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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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NEW PROJECT ANALYSIS You must analyze a potential new product—a caulking compound that Cory Materials' R&D people developed for use in the residential construction industry. Cory's marketing manager thinks the company can sell 115,000 tubes per year at a price of $3.25 each for 3 years, after which the product will be obsolete. The required equipment would cost $150,000, plus another $25,000 for shipping and installation. Current assets (receivables and inventories) would increase by $35,000, while current liabilities (accounts payable and accruals) would rise by $15,000. Variable cost per unit is $1.95, fixed costs (exclusive of depreciation) would be $70,000 per year, and fixed assets would be depreciated under MACRS with a 3-year life. (Refer to Appendix 12A for MACRS depreciation rates.) When production ceases after 3 years, the equipment should have a market value of $15,000. Cory's tax rate is 40%, and it uses a 10% WACC for average-risk projects.

  1. a. Find the required Year 0 investment and the project's annual cash flows. Then calculate the project's NFV, IRR, MIRR, and payback. Assume at this point that the project is of average risk.
  2. b. Suppose you now learn that R&D costs for the new product were $30,000 and that those costs were incurred and expensed for tax purposes last year. How would this affect your estimate of NPV and the other profitability measures?
  3. c. If the new project would reduce cash flows from Cory's other projects and if the new project would be housed in an empty building that Cory owns and could sell, how would those factors affect the project's NPV?
  4. d. Are this project's cash flows likely to be positively or negatively corrected with returns on Cory's other projects and with the economy, and should this matter in your analysis? Explain.
  5. e. Spreadsheet assignment: at instructor's option Construct a spreadsheet that calculates the cash flows, NFV, IRR, payback, and MIRR.
  6. f. The CEO expressed concern that some of the base-case inputs for the caulking compound might be too optimistic or too pessimistic, and he wants to know how the NPV would be affected if these six variables were 20% above or 20% below the base-case levels: unit sales, sales price, variable cost, fixed costs, WACC, and equipment cost. Hold other things constant you consider each variable and construct a sensitivity graph to illustrate your results.
  7. g. Do a scenario analysis based on the assumption that there is a 25% probability that each of the six variables itemized in part f will turn out to have their best-case values as calculated in part f, a 50% probability that all will have their base-case values, and a 25% probability that all will have their worst-case values. The other variables remain at base-case levels. Calculate the expected NPV, the standard deviation of NPV, and the coefficient of variation.
  8. h. Does Cory's management use the risk-adjusted discount rate to adjust for project risk? Explain.

a.

Summary Introduction

To compute: The investment required in year 0, NPV, IRR, MIRR and payback of the project.

Introduction:

Net Present Value (NPV):

NPV is the technique of capital budgeting. To select the project or not is dependent on the NPV of the project. If the project has positive NPV than accept the project if the NPV is negative than reject the project.

Internal Rate of Return (IRR):

IRR is a capital budgeting technique that involves the time value of money concept. The IRR percentage gives the idea about the profitability arises from an investment. The IRR of a project is calculated with the help of NPV calculations.

Modified Internal Rate of Return (MIRR):

It is also a kind of technique used in capital budgeting while selecting a project. It is modified version of the IRR and commonly used in large-scale business to purchase heavy investment.

Payback period:

It is ascertained when the cost of the project is divided by the annual cash flows of the respective project. The payback period is a method used in capital budgeting. It does not involve the time value of money factor.

Scenario Analysis:

Under this analysis, the management considers the different alternatives outcome to analyze the future events. It is the method in which the analyst estimates the expected future value after a period of time.

Explanation

Given information:

Cost of the machine is $150,000.

Installation cost is $25,000.

Estimated value after 3 years is $15,000.

Depreciation rate under MACRS method is 33%, 45%, 15%, and 7%.

Increase in the current asset is $35,000.

Increase in current liability is $15,000.

Net operating working capital is increased by $20,000.

The tax rate is 40%.

Weighted average cost of capital is 10%.

Formula to calculate initial investment:

Initialinvestment=(Costofmachine+Installationcost+Increaseinnetworkingcapital)

Substitute $150,000 for cost of machine, $25,000 for installation cost and $20,000 for increase in net working capital,

Initialinvestment=$150,000+$25,000+$20,000=$195,000

Here, the investment required in year 0 is $195,000.

For NPV

Calculated values (working note),

The present value of cash inflow is $198,943.5.

The present value of cash outflow is $195,000.

Formula to calculate net present value is:

Net present value= Present value of cash inflowPresent value of cash outflow

Substitute $198,943.5 for the present value of cash inflow and $195,000 for the present value of cash outflow,

Net present value=$198,943.5$195,000=$3,943.5

For IRR

Calculated values (working note):

Present value factors are 10%.

NPV at 10% is $3,943.5.

Calculate IRR,

Table (1)

For MIRR,

Year

Amount

($)

Future discount

Factor at 10%

Future value

($)

392,1001.3310122,585.1
279,2001.210095,832
170,8001.100077,880
Total  296,297.1

Table (2)

The formula to calculate MIRR:

MIRR=Sum of Future value of cash flowsSum of present values of cash flows1

Substitute $291,376.8 for sum of future cash flow and $242,100 for the sum of present values of cash flows,

MIRR=$291,376.8$242,1001=1.0971=0.097or9.70%

For payback period,

The formula to calculate the payback period:

Payback Period=[Year upto which cummulative cash flow are equal to project cost+(Cost of projectCummulative cash flowsCash flow of the year)]

Substitute $124,200 for the cost of the project, 2 years for years up to which cumulative cash flow is equal to project cost, $79,200 for cumulative cash flows and $92,100 for the cash flow of the year,

Payback period=2years+($124,200$79,200)$92,100=2years+$45,000$92,100=2years+0.49=2

b.

Summary Introduction

To compute: NPV where R & D cost is $30,000.

c.

Summary Introduction

To identify: The effect of other factors on NPV of the project.

d.

Summary Introduction

To identify: The correlation of one project with other projects and whether it affects the analysis.

e.

Summary Introduction

To identify: The NPV, IRR, and MIRR of the project in a spreadsheet.

f.

Summary Introduction

To prepare: The sensitivity graph.

g.

Summary Introduction

To identify: The expected NPV, the standard deviation of NPV and coefficient of variation.

h.

Summary Introduction

To identify: Whether the management uses the risk-adjusted discount rate to adjust for project risk.

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