Finance Capital Budgeting

Drillmaster Sdn Bhd has developed a powerful new hand drill that would be used for woodwork and carpentry activities. It would cost $1 million to buy the equipment necessary to manufacture the drills, and it would require net operating working capital equal to 10% of sales. It would take 1 year to buy the required equipment and set up operations, and the project would have a life of 5 years. If the project is undertaken, it must be continued for the entire 5 years.

The firm believes it could sell 10,000 units per year. The drills would sell for $240 per unit, and Webmasters believes that variable costs would amount to $175 per unit. The company's non-variable costs would be $100,000 at Year 1 and would increase with inflation. After the first year the sales price and variable costs will increase at the inflation rate of 3%.

The equipment would be depreciated over a 5-year period, using the straight-line method. The estimated market value of the equipment at the end of the project's 5-year life is $100,000. The tax rate is 25%.

Also, the project's returns are expected to be highly correlated with returns on the firm's other assets. 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%.

a. Develop a spreadsheet model and use it to find the project's NPV, IRR, and payback.

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

c. Conduct a scenario analysis. Assume that there is a 30% probability that best-case conditions, with the sales price, number of units sold , variable costs per unit and fixed cost being 20% better than its base-case value. There is a 30% probability of worst-case conditions, with the variables 20% worse than base value. The base case condition is assumed to have a 40% probability. What would be the project's coefficient of variation NPV?

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