Illinois Fabrics Inc. makes upholstery thats used in high-quality furnture, largely chairs and sofas. Illinois has traditionally
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Illinois’ VP of Manufacturing, Harrison Flatley, has proposed starting a new business called Illinois Furniture which will produce and market the end product using the fabric the firm already manufactures. Harrison has put together a proposal to start such a venture which results in a steady stream of cash income of $5 million per year after an initial investment of $25 million to be spent on manufacturing facilities and the development of a sales relationship with retailers. The analysis comes up with an NPV for the project assuming the income stream is a perpetuity and taking its present value at Illinois’ 10% cost of capital.
NPV= -$25M + $5M/.10= -$25M + $50M =$25M
Top management likes the idea but is concerned about risk in two areas. First, furniture manufacturing seems to be a riskier business than making fabric as manufacturing firms are always entering and leaving the industry. The average beta of the publicly traded end product manufacturers is a relatively high 1.9. By contrast, Illinois’ beta is .9. Second, management fears that an economic downturn would impact a new business more seriously than it would the existing competitors. Management fears that there’s a 40% chance of a downturn in the near future which would reduce Harrison’s income projections by 20%. Re-analyze Harrison’s proposal and make a recommendation to management. Treasury bills are yielding 4% and the S&P 500 index is yielding 10%.
Perpetuity
Perpetuity refers to payments that are made without an end or maturity date. A perpetuity is classified as an annuity, which is something that earns a dividend or receives a payment at a regularly scheduled interval, generally yearly. So, how...
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