Question
ABC is considering a project to manufacture a new product and has paid $60,000 for market research. Here are the details. The project would use
ABC is considering a project to manufacture a new product and has paid $60,000 for market research. Here are the details.
The project would use a warehouse that ABC already owns, but is currently leased to another company. Next year, the annual rental revenue will be $100,000. In subsequent years, annual rental revenues are expected to grow at a rate equal to annual inflation (4%).
In addition, the project requires an investment of $1,200,000 in equipment. The amortization of the equipment is calculated using the declining balance method at a constant rate of 20% (reminder: Annual amortization expense = Book value at the beginning of the year * constant rate). Abc expects to complete the project at the end of the tenth year and to sell the equipment at the end of the tenth year for $300,000.
Under normal conditions, the company expects sales of the new product to be $4,200,000 for the first year and to grow at a rate of 5% per year for subsequent years. The project will also generate additional annual revenues (special revenues that do not come directly from the sale of the product) at a value of 2% of the expected annual revenues for the new product.
The project requires an initial working capital investment of $350,000. Then, the company expects annual working capital costs to be 10% of the expected annual revenues for the new product for years 1 through 10. Finally, ABC estimates that annual manufacturing costs will be 90% of sales. The firm's tax rate is 35% and the cost of capital is 12%.
Part 1a:
What is the NPV of ABCs project?
Part 1b:
ABCs managers understand that economic conditions can change. Therefore, the managers consider two possibilities:
(a) Best-case scenario: expected annual revenue growth for the new product will be 7% for years 3-4, 4-5, 5-6, and 6-7 (instead of the 5% mentioned).
b) Worst case scenario: the projected annual revenue growth for the new product will be 4% in years 2-3, 3-4, 4-5, 5-6, 6-7 and 7-8 (instead of the 5% mentioned).
The probabilities for the Normal, Best and Worst scenarios are 50%, 30% and 20% (respectively). The NPV calculation follows the following formula: NPV = Probability of Normal scenario * NormalVAN + Probability of Best scenario * BestVAN + Probability of Worst scenario * WorstVAN Using this formula, what is the NPV of the ABC project?
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