George Company is considering adding a new line to its current product mix and the capital budgeting analysis is being managed by John. The production facilities would be set up in an unused section of George's main plant. New machinery with an estimated cost of $8 million would be purchased, but shipping costs to move the machinery to Georges plant would total $300,000, and installation charges would add another $500,000 to the total equipment cost. Additional initial expenses would run $250,000 to train employees to operate the new machinery. Furthermore, Georges working capital is estimated to be 5% of sales revenue for the initial investment (to support first years sales and would continue to be 5% for the increase in sales for the rest of the the life of the project. The machinery has an economic life of 4 years, and the company has obtained a special tax ruling that allows it to depreciate the equipment, under the MACRS 3-year class (0.33, 0.45, 0.15 and 0.07 in Years 1 through 4, respectively). The machinery is expected to have a salvage value of $500,000 after 4 years of use and is expected to be sold.

The section of the plant in which production would occur had not been used for several years and, consequently, had suffered some deterioration. An investment of $300,000 will have to be spent to get it completely ready as a production facility. (For simplicity sake, assume this expenditure is not depreciable.)

Georges management expects to sell 300,000 units in year 1 and anticipates that sales in units to remain constant. Todays selling price would be $25 per unit but due to inflation the selling price is expected to increase by 5% each year, so year 1 selling price is expected to be $26.25. Cash operating costs today would be $10 per unit but are expected to increase by only 3% annually (so year 1 operating cost is expected to be $10.30) from the initial cost estimate because over half of the costs are fixed by long-term contracts. For simplicity, assume no other cash flows are affected by inflation (externalities, working capital, etc.). Georges federal-plus-state tax rate is 40 percent, and its overall cost of capital is 18 percent. Due to obsolescence of inventory, it is assumed only half of NWC investments can be recaptured at the end of the life of the project.

It was also determined that the executive committee would want to see a thorough risk analysis on the project. As the meeting was winding down, Smith was asked to develop a base case set of cash flows and then to perform a sensitivity analysis of plus and minus 30%, 20% and 10% from the base cash flow estimates for 2 risk factors. The risk factors are 1) number of units sold 2) price per unit (note: Begin the sensitivity analysis by changing the price in year 1 by each of the percentages rather than changing the base price. For example, the problem states that the base price today is $25 and so year 1 price will be $26.50 due to inflation. Begin your sensitivity by changing the $26.50 price by plus and minus 30%, 20% and 10% and assume the same 5% inflation rate thereafter.)

Smith met with the marketing and production managers to get a feel for the uncertainties involved in the cash flow estimates. After several sessions, they concluded that unit sales and sales price provided the most uncertainty. Costs estimates were fairly well defined. As estimated by the

marketing staff, if product acceptance were normal, then sales quantity during Year 1 would be 300,000 units (and constant) with a year 1 selling price of $26.25; if acceptance were poor, then only 200,000 units would be sold the first year (and constant) with a year 1 selling price of $20.00; and if acceptance were strong, then sales volume for Year 1 would be 350,000 units (and constant) with a year 1 selling price of $30.00. In all cases, the price would increase at the inflation rate of 5% per year as in the original base case and costs would be expected to increase at a 3% rate and NWC would still be 5% of revenues.

Smith also discussed the scenarios probabilities with the marketing staff. After considerable debate, they finally agreed on a guesstimate of a 15% probability of poor acceptance, a 70% probability of average acceptance, and a 15% probability of excellent acceptance.

Smith also researched the risk inherent in George's average project and how the company typically adjusts for risk. Based on historical data, Georges average project has a coefficient of variation of NPV in the range of 2 to 2.50. You have been asked to assist in the project and are responsible for answering the following questions.

Questions (Perform all calculations in Excel and have a separate spreadsheet for each sensitivity calculation and scenario calculation)

Compute the base case cash flow estimates for the project (Net investment, Operating CFAT and Terminal Cash Flow).

Compute the NPV, IRR, MIRR and PI for the base cash flows. Explain your results.

Perform a sensitivity analysis of NPV assuming the 2 risk variables given in the case. Assume that each of these variables can deviate from its base case by plus or minus 10%, 20% and 30%. Create an NPV matrix and explain your results.

Complete a scenario analysis assuming a worst case, base case, and best case using the data presented in the case. Explain your results.

Based on the scenario results, what is the expected NPV, standard deviation, and coefficient of variation? How does the risk of this project compare to other projects the firm is invested? (10 points)

Would you recommend investing? Why or why not? Explain your results.

Please answer the following questions: (A )Explain how the cost of capital is an integral part of the capital budgeting process and why firms seek to minimize their cost of capital. (B) What actions can management take to try to decrease the firms cost of capital? (C) What forces are out of their control that may impact the cost of capital?