Finance 630 Ch. 11 problems 18

Webmasters.com 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 year's projected sales; for example, NWC0 = 10%(Sales1).

The firm believes it could sell 1,000 units per year. The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $18,000 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 3%. The companys non variable costs would be $1 million at Year 1 and also would increase at the 3% inflation rate.

The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of the equipment at the end of the projects 4-year life is $500,000.

Webmasters federal-plus-state tax rate is 25%. Its cost of capital is 10% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 and 1.2. Low-risk projects are evaluated with a WACC of 8%, and high-risk projects at 13%. Also, the project's returns are expected to be highly correlated with returns on the firm's other assets.

a. Develop a spreadsheet model and use it to find the projects NPV, IRR, and payback.

b. Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and the number of units sold. Set these variables values at 10% and 20% above and below their base-case values. Include a graph in your analysis.

c. Now conduct scenario analysis. Assume that there is a 25% probability that best-case conditions, with each of the variables discussed in Part b being 20% better than its base-case value, will occur. There is a 25% probability of worst-case conditions, with the variables 20% worse than base, and a 50% probability of base-case conditions. (Hint: Use Scenario Manager. Go to the Data menu, choose What-If-Analysis, the choose Scenario Manager. After you create the Scenario, you can pick a scenario and type in the resulting NPV (but be sure to return the Scenario to the base case afterward). Or you can create a Scenario Summary and use a cell reference to the Scenario Summary worksheet to show the NPV for each scenario.)

d. If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and payback.

e. On the basis of information in the problem, would you recommend that the project be accepted?