Capital Budgeting

FuncoLand has developed a powerful new server that would be used for corporations Internet activities. It would cost $10 million at Year 0 to buy the equipment necessary to manufacture the server. The project would require net working capital at the beginning of each year in an amount equal to 10% of the years projected sales; for example, NWC0 = 10% (Sales1). The servers would sell for $24,000 per unit, and Web- masters believes that variable costs would amount to $17,500 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 3%. The companys nonvariable costs would be $1 million at Year 1 and would increase with inflation. The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. Also, the projects returns are expected to be highly correlated with returns on the firms other assets. The firm believes it could sell 1,000 units per year. The equipment would be depreciated over a 5-year period, using MACRS rates (see page 500). The estimated market value of the equipment at the end of the projects 4-year life is $500,000. FuncoLands federal-plus-state tax rate is 40%. Its cost of capital is 10%.

Part 1: Cash Flow Estimation

A) Fill in the input data for the model. (8 points)

B) Calculate the sales revenues for each year. (8 Points)

C) Calculate the net cash flow due to salvage. (8 Points)

D) Calculate net cash flows for each year. (8 Points)

Part 2: Capital Budgeting Analysis

E) Calculate the NPV, IRR, MIRR, Payback and Discounted Payback. (8 Points)

Part 3: Risk Analysis

F) Conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price. Set the variables values at 10% and 20% above and below their base-case values. Include a graph in your analysis of the NPV on the y-axis and the percent deviation from base on the x- axis. Label the title and axes. (8 Points)

G) Conduct a scenario analysis. Assume that there is a 25% probability that best-case conditions, 25% probability of worst-case conditions, and a 50% probability of base-case conditions will occur. Calculate the expected NPV. (8 Points)

A) Input Data Input Data Equipment cost Net operating working capital/Sales First year sales (in units) Sales price per unit Variable cost per unit (excl. depr.) Nonvariable costs (excl. depr) Market value of equipment at Year 4 Tax rate WACC Inflation in prices and costs B) Sales Revenues Sales Revenues Year Units sold Sales price per unit (excl. depr.) Variable costs per unit (excl. depr.) Nonvariable costs (excl. depr.) Variable costs Sales revenue Net operating working capital L 0 1 2 3 4