Free Cash Flow Construction and NPV / IRR Estimation

RIC's research and development department has developed a small micro-processor and sensor system specifically designed to control commercial landscape watering systems. Once programmed, the system would automatically sense the need for watering in each separate watering zone and then provide just the right amount of water to each zone. The project has now reached the stage where a decision must be made on whether to go forward with production.

The firm would need a new plant, which could be built and made ready for production two years after the "go" decision is made. The plant would require a 25-acre site, and RIC currently has an option to purchase a suitable tract for $1.2 million; the option could be exercised in late 1999. Building construction would begin in early 2000 and would continue through 2001. The building, which according to a special tax ruling has a MACRS 31.5 year recovery period, would cost an estimated $8 million; a $4 million payment would be made on December 31, 2000, and the remaining $4 million would be paid on December 31, 2001.

The necessary equipment would be installed late in 2001 and would be paid for on December 31, 2001. The equipment has a MACRS five year recovery period and would cost $10 million.

The project would also require an initial investment in net working capital equal to 12 percent of the estimated sales in the first year. The initial working capital investment would be made on December 31, 2001, and on December 31 of each following year net working capital would be increased by an amount equal to 12% of any sales increase expected during the coming year. The project's expected economic life is 6 years. At that time, the land is expected to have a market value of $1.7 million, the building a value of$1 million, and the equipment a value of $2 million. The marketing vice president believes that annual sales would be 25,000 units if the systems were priced at $2,200 each. The production department has estimated that the variable manufacturing costs would total about 65% of dollar sales, and that fixed overhead costs, excluding depreciation, would be $8 million for the firstyear of operations. Sales price and fixed overhead costs, other than depreciation, are projected to increase with inflation, which is expected to average 6% per year over the six year life of the project.

RIC's marginal federal-plus-state tax rate is 40%; its weighted average cost of capital is 11.5%; and the company's policy, for capital budgeting purposes is to assume that cash flows occur at the end of each year. Since the plant would begin operation on January 1, 2002, the first operating cash flows would be realized on December 3, 2002.

As one of the company's financial analysts, you have been assigned to conduct the capital budgeting analysis. For now, you may assume that the project has the same risk as the firm's existing assets; hence you may use the corporate cost of capital, 11.5%, for this project.

Risk Analysis of the Project

Perform the risk analysis of the project.

Sensitivity Analysis:

What if unit sales fall by 20 percent below the most likely level?

What if the sales price per unit falls?

What if the variable costs are 65 percent of dollar sales rather than the expected 60 percent?

Scenario Analysis:

RIC managers are fairly confident of their estimates for all the project's cash flow variables except price and unit sales. Further, they regard a drop in sales below 15,000 units or a rise above 35,000 units as being extremely unlikely. Similarly, they expect the sales price as set in the marketplace to lie within the range of $1,700 to $2,700. Thus 15,000 units at a price of $1,700 defines the lower bound, or the worst-case scenario, whereas 35,000 units at a price of $2,700 defines the upper bound or best-case scenario (with the probability of 25% each). Remember that the base-case values are 25,000 units at a price of $2,200.

Monte Carlo Simulation:

Perform a simulation analysis on RIC's watering system project assuming that sales price is normally distributed with mean of $2,200 and standard deviation of approximately $167 (we reached this number by dividing 500 by 3 where 500 plus/minus is the maximum range of the price as outlined before). Moreover, also assume that the expected units of sales are 25,000 and sales can go as high as 40,000 units (max production capacity) in case of excess demand and can go as low as 10,000 in case of low demand.