PROJECT AND RISK ANALYSIS As a financial analyst, you must evaluate a proposed project to produce printer cartridges. The equipment would cost $55,000, plus $10,000 for installation. Annual sales would be 4,000 units at a price of $50 per cartridge, and the project’s life would be 3 years. Current assets would increase by $5,000 and payables by

$3,000. At the end of 3 years the equipment could be sold for $10,000. Depreciation would be based on the MACRS 3-year class, so the applicable rates would be 33%, 45%, 15%, and 7%. Variable costs would be 70% of sales revenues, fixed costs excluding depreciation would be $30,000 per year, the marginal tax rate is 40%, and the corporate WACC is 11%.

a. What is the required investment, that is, the Year 0 project cash flow?

b. What are the annual depreciation charges?

c. What are the project’s annual cash flows?

d. If the project is of average risk, what is its NPV? Should it be accepted?

e. Management is uncertain about the exact unit sales. What would the project’s NPV be if unit sales turned out to be 20% below forecast but other inputs were as forecasted?

Would this change the decision? Explain.

f. The CFO asks you to do a scenario analysis using these inputs:
Probability Unit Sales VC%
Best case 25% 4,800 65%
Base case 50 4,000 70 Worst case 25 3,200 75 Other variables are unchanged. What are the expected NPV, its standard deviation, and the coefficient of variation? [Hint: To do the scenario analysis, you must change unit sales and VC% to the values specified for each scenario, get the scenario cash flows, and then find each scenario’s NPV. Then you must calculate the project’s expected NPV, standard deviation , and coefficient of variation (CV). This is not difficult, but it would require a lot of calculations. You might want to look at the answer in Appendix A at the back of the text, but make sure you understand how it was calculated.]
g. The firm’s project CVs generally range from 1 0 to 1 5. A 3% risk premium is added to the WACC if the initial CV exceeds 1 5, and the WACC is reduced by 0 5% if the CV is 0 75 or less. Then a revised NPV is calculated. What WACC should be used for this project when project risk has been properly considered? What are the revised values for the NPV, standard deviation, and coefficient of variation? Would you recommend that the project be accepted? Why or why not?

AppendixLO1