HMG Corporation is considering the manufacture of a new

chemical compound that is used to make high-pressure plastic containers. An investment

of $4 million in plant and equipment is required. The firm estimates that the investment

will have a five-year life, and will use straight-line depreciation toward a zero salvage value.

However, the investment has an anticipated salvage value equal to 10% of its original cost.

The number of pounds (in millions) of the chemical compound that HMG expects to

sell over the five-year life of the project are as follows: 1.0, 1.5, 3.0, 3.5, and 2.0. To operate

the new plant, HMG estimates that it will incur additional fixed cash operating expenses

of $1 million per year and variable operating expenses equal to 45% of revenues. HMG

also estimates that in year t it will need to invest 10% of the anticipated increase in revenues

for year t + 1 in net working capital. The price per pound for the new compound is

expected to be $2.00 in years 1 and 2, then $2.50 per pound in years 3 through 5. HMGs

tax rate is 38%, and it requires a 15% rate of return on its new-product investments.

a. Exhibit P2-11.1 contains projected cash flows for the entire life of the proposed

investment. Note that investment cash flow is derived from the additional revenues

and costs associated with the proposed investment. Verify the calculation of project

cash flow for year 5.

b. Does this project create shareholder value? How much? Should HMG undertake

the investment? Explain your answer.

c. What if the estimate of the variable costs were to rise to 55%? Would this affect

your decision?

Investment Plant life Salvage value Variable Cost % Fixed operating cost Tax rate Working capital Required Rate of Return Given $ (4,000,000) 5 $ 400,000 45% $ 1,000,000 38% 10% Change in revenues 15% Exhibit P2-9.1 0 1 Year 2 1,500,000 $ 2.00 $ Sales volume Unit Price 1,000,000 $ 2.00 3 3,000,000 $ 2.50 4 3,500,000 $ 2.50 5 2,000,000 2.50 Revenues Variable Operating costs Fixed Operating Costs Depreciation Expense Net Operating Income Less: Taxes NOPAT Plus: Depreciation Less: CAPEX Less: Working Capital Free Cash Flow 2,000,000 (900,000) (1,000,000) (800,000) (700,000) $ 266,000 (434,000) $ 800,000 3,000,000 (1,350,000) (1,000,000) (800,000) (150,000) $ 57,000 (93,000) $ 800,000 7,500,000 (3,375,000) (1,000,000) (800,000) 2,325,000 $ (883,500) 1,441,500 $ 800,000 8,750,000 (3,937,500) (1,000,000) (800,000) 3,012,500 $ (1,144,750) 1,867,750 $ 800,000 $ 5,000,000 (2,250,000) (1,000,000) (800,000) 950,000 (361,000) 589,000 800,000 248,000 500,000 2,137,000 $ (4,000,000) (200,000) (4,200,000) $ (100,000) 266,000 $ (450,000) 257,000 $ (125,000) 2,116,500 $ 375,000 3,042,750 $ $ $ NPV IRR 419,435 18% Investment Plant life Salvage value Variable Cost % Fixed operating cost Tax rate Working capital Required Rate of Return Given $ (4,000,000) 5 $ 400,000 45% $ 1,000,000 38% 10% Change in revenues 15% Exhibit P2-9.1 0 1 Year 2 1,500,000 $ 2.00 $ Sales volume Unit Price 1,000,000 $ 2.00 3 3,000,000 $ 2.50 4 3,500,000 $ 2.50 5 2,000,000 2.50 Revenues Variable Operating costs Fixed Operating Costs Depreciation Expense Net Operating Income Less: Taxes NOPAT Plus: Depreciation Less: CAPEX Less: Working Capital Free Cash Flow 2,000,000 (900,000) (1,000,000) (800,000) (700,000) $ 266,000 (434,000) $ 800,000 3,000,000 (1,350,000) (1,000,000) (800,000) (150,000) $ 57,000 (93,000) $ 800,000 7,500,000 (3,375,000) (1,000,000) (800,000) 2,325,000 $ (883,500) 1,441,500 $ 800,000 8,750,000 (3,937,500) (1,000,000) (800,000) 3,012,500 $ (1,144,750) 1,867,750 $ 800,000 $ 5,000,000 (2,250,000) (1,000,000) (800,000) 950,000 (361,000) 589,000 800,000 248,000 500,000 2,137,000 $ (4,000,000) (200,000) (4,200,000) $ (100,000) 266,000 $ (450,000) 257,000 $ (125,000) 2,116,500 $ 375,000 3,042,750 $ $ $ NPV IRR 419,435 18%