Capital Budgeting Project Risk Analysis Ch 11 Mini-Case/Homework TIVO's R&D team came up with a new high-tech TV recording system. The new system targets wealthy households and is priced 5 times higher than TiVo's other recording systems. The firm conducted consumer tests with the new product and expects that it will sell well. The firm's accounting department produced pro-forma financial statements that show the project's relevant cash flows (see spreadsheets below, you can also download them as Excel templates from Blackboard). The accounting department's projections are based on the below assumptions. Baseline case assumptions and information: The new recording system is not expected to compete with the firm's existing systems, so financially it can be treated as a completely stand-alone project. The new recording system's sales forecasts over a 10 year period are shown in table 1. The firm spent $2,000,000 in R&D expenses to develop this new TV recording system. To produce the new product, the firm must invest $19.9 million in new equipment. New equipment shipping and Installation costs would total $100,000 The newly purchased fixed assets will be depreciated using 7-year MACRS (see table 2). The firm believes that it can produce the new product for 10 years, then will sell all foxed assets associated with this project for $4 million, The firm currently has no space to house the new product line, so it plans to rent a manufacturing space for $10,000 per month Fixed costs associated with this production are expected to be $1.5 million per year. Variable costs are expected to be $400 per unit. In the beginning of the project, the firm will need to invest in additional working capital as follows: add $500,000 to inventory purchases, $1 million to accounts receivables, $600,000 to accounts payables. In the final year, the firm's working capital will decrease by the same amounts, as the firm will end production of this product The firm's weighted average cost of capital is 14% per year. The firm will borrow funds for this project, with interest on debt expected to be around $400,000 per year. The firm is subject to a corporate tax rate of 40%. Table 1. Sales Forecast Year Quantity sold Price per i 1 3 4 5 6 7 9 10 30,000 4,000 35.00 38.000 1.000 1.00035,500 35,000 34.500 34.000 $1,000 $1,000 $1,000 $90 $950 $950 $950 $900 5900 SO Table 2.7 Year MACRS 4 2 Yew De Rate 1 14% 5 9% 6 9% 7 9% 8 4% 18% 125 FOCUS Normal NO DE Table 1. Sales Forecast Year Quantity sold Price per unit 1 1 2 3 4 5 6 7 8 9 10 30,000 34,000 38,800 38,000 36,000 36,000 35,500 35,000 34,500 34,000 $1,000 $1,000 $1,000 $950 $950 $950 $950 $900 $900 $900 Table 2.7 Year MACRS Year 1 14% 2 25% 3 18% 4 12% 5 9% 6 9% 7 9% 8 4% ReRe Rate Before producing the product for the mass market, the firm's Capital Investment Committee requested you to analyze the project's risks. Assume the firm's cost of capital is constant at 14%. Given this information, complete the following tasks: 1. Find the project's baseline NPV, IRR and Pl using the baseline pro-forma financial statement. (10 points) 2. Perform sensitivity analysis (10 points) showing how the project's NPV, IRR and PI will change with the following a. 1% decrease in product's price, b. 1% decrease in forecasted annual quantity, c 1% increase in variable cost per unit. d. Which two of these factors have the most impact on NPV? IRR? PI? 1. Perform scenario analysis showing how the project's NPV, IRR and Pl will change if the project's two most sensitive factors (a) both increase by 10% (best case scenario). (b) both decrease by 10% (worst case scenario) 110 points 4. Given the above scenario analysis, find the expected NPV, IRR and Pl, if the baseline scenario has a probability of com, best-case scenario has a probability of 20%, and worst case scenario has a probability of 20% (10 points) 5. Using the above expected NPV and IRR, explain whether there is any risk that the project's NPV falls below zero and I falls below the annual cost of capital of 14% (10 points) .tates Focus Capital Budgeting Project Risk Analysis Ch 11 Mini-Case/Homework TIVO's R&D team came up with a new high-tech TV recording system. The new system targets wealthy households and is priced 5 times higher than TiVo's other recording systems. The firm conducted consumer tests with the new product and expects that it will sell well. The firm's accounting department produced pro-forma financial statements that show the project's relevant cash flows (see spreadsheets below, you can also download them as Excel templates from Blackboard). The accounting department's projections are based on the below assumptions. Baseline case assumptions and information: The new recording system is not expected to compete with the firm's existing systems, so financially it can be treated as a completely stand-alone project. The new recording system's sales forecasts over a 10 year period are shown in table 1. The firm spent $2,000,000 in R&D expenses to develop this new TV recording system. To produce the new product, the firm must invest $19.9 million in new equipment. New equipment shipping and Installation costs would total $100,000 The newly purchased fixed assets will be depreciated using 7-year MACRS (see table 2). The firm believes that it can produce the new product for 10 years, then will sell all foxed assets associated with this project for $4 million, The firm currently has no space to house the new product line, so it plans to rent a manufacturing space for $10,000 per month Fixed costs associated with this production are expected to be $1.5 million per year. Variable costs are expected to be $400 per unit. In the beginning of the project, the firm will need to invest in additional working capital as follows: add $500,000 to inventory purchases, $1 million to accounts receivables, $600,000 to accounts payables. In the final year, the firm's working capital will decrease by the same amounts, as the firm will end production of this product The firm's weighted average cost of capital is 14% per year. The firm will borrow funds for this project, with interest on debt expected to be around $400,000 per year. The firm is subject to a corporate tax rate of 40%. Table 1. Sales Forecast Year Quantity sold Price per i 1 3 4 5 6 7 9 10 30,000 4,000 35.00 38.000 1.000 1.00035,500 35,000 34.500 34.000 $1,000 $1,000 $1,000 $90 $950 $950 $950 $900 5900 SO Table 2.7 Year MACRS 4 2 Yew De Rate 1 14% 5 9% 6 9% 7 9% 8 4% 18% 125 FOCUS Normal NO DE Table 1. Sales Forecast Year Quantity sold Price per unit 1 1 2 3 4 5 6 7 8 9 10 30,000 34,000 38,800 38,000 36,000 36,000 35,500 35,000 34,500 34,000 $1,000 $1,000 $1,000 $950 $950 $950 $950 $900 $900 $900 Table 2.7 Year MACRS Year 1 14% 2 25% 3 18% 4 12% 5 9% 6 9% 7 9% 8 4% ReRe Rate Before producing the product for the mass market, the firm's Capital Investment Committee requested you to analyze the project's risks. Assume the firm's cost of capital is constant at 14%. Given this information, complete the following tasks: 1. Find the project's baseline NPV, IRR and Pl using the baseline pro-forma financial statement. (10 points) 2. Perform sensitivity analysis (10 points) showing how the project's NPV, IRR and PI will change with the following a. 1% decrease in product's price, b. 1% decrease in forecasted annual quantity, c 1% increase in variable cost per unit. d. Which two of these factors have the most impact on NPV? IRR? PI? 1. Perform scenario analysis showing how the project's NPV, IRR and Pl will change if the project's two most sensitive factors (a) both increase by 10% (best case scenario). (b) both decrease by 10% (worst case scenario) 110 points 4. Given the above scenario analysis, find the expected NPV, IRR and Pl, if the baseline scenario has a probability of com, best-case scenario has a probability of 20%, and worst case scenario has a probability of 20% (10 points) 5. Using the above expected NPV and IRR, explain whether there is any risk that the project's NPV falls below zero and I falls below the annual cost of capital of 14% (10 points) .tates Focus