A firm plans to produce and sell a new product for five years. First year sales of this product are expected to be 200,000 units and sales are expected to grow at 3.5% for years 2-3 and then at 4% for years 4-5. Selling price per unit of the product is $50 and variable operating costs are 48 percent of sales. The product will have fixed operating costs of $850,000 a year for the first 3 years and then $900,000 per year for the last two years.

The firm will also need to purchase some new equipment for $10 million in order to produce this product. This equipment has a five-year life and salvage value of $5.2 million. The new equipment will replace some old equipment which was purchased 2 years ago (expected life at that time of 6 years) for $3.5 million and a salvage value of $500,000 at the end of the expected six-year life. The firm expects to be able to sell the old equipment for $1.2 million today.

Depreciation is straight-line on both old and new machines and the firm's tax-rate is 35%. The new equipment that is purchased will be financed through debt at a rate of 8% per year. Test marketing costs of $400,000 for the new product were incurred last month. The new product is also expected to reduce sales of one of the firm's existing products by $520,000 per year. The firm is financed with 60% debt and 40% equity; it has a beta of 1.4; the debt YTM is 8.25% before -tax. The expected return on the S&P500 is 13% and the return on 90-day T-Bills is 5%.

Any annual working capital can be ignored.

Required:

(a) Set up a data table and then calculate the expected cash flows for the project.

(b) Find the NPV, PI, IRR of this project for the "base case" above.

(c) Conduct a sensitivity analysis varying the NPV over discount rates starting from 3% and going up to 30%, increasing the rate by 3% each time. Graph the NPV against the discount rates.

(d) What selling price (per unit) will be needed to obtain an NPV of $3.5million?

(e) Conduct a scenario analysis for an optimistic scenario (where the selling price is $80 per unit, variable operating costs are $7 per unit and starting sales are 250,000 units) and, separately, for a pessimistic scenario (where the selling price is $55 per unit, variable operating costs are $8.50 per unit, and first-year sales are only 180,000 units).