In part I, Maria and Robert analyzed a lite orange pineapple cocktail project for Orange Delight, Inc. The project is expected to require an initial investment of in fixed assets (including shipping and installation charges), plus a $ 14,000 addition to net working capital. The machinery would be used for 4 years and be depreciated on the basis of a 3-year MACRS class life. The appropriate MACRS depreciation allowances are 0.33.0.45, 15, and 0.07 in Years 1 through 4, respectively, and the machinery is expected to have a salvage of $45,000. If the project is undertaken, the firm expects to sell 350,000 cartons of lite orange pineapple juice at a current dollar (Year O) wholesale price of $2.50 per carton. However, the sales price will be adjusted for inflation, which is expected to average 5 percent annually, so the actual expected sales price at the end of the first year is $2.63, the expected price at the end of the second year is $2.76, and so on.

Because the two product lines are somewhat competitive, the lite orange pineapple project is

expected to cannibalize the before-tax profit Orange Delight earns on its regular orange pineapple sales by $20,000. Fixed costs (other than depreciation) associated with the production of the lite product are expected to be $150,000 per year, and Year O variable costs per unit are estimated at $1.55. Variable costs per unit are expected to increase by 2 percent per year. Orange Delight's tax rate is 40 percent, and its cost of capital for an average project is 10 percent. (All of this data is the same as part I.)

When Marja and Robert presented their initial analysis of Orange Delight's executive committee, things went well, and they were congratulated on both their analysis and their presentation. However. several questions were raised. In particular, the executive committee wanted to see more risk analysis on the projectit appeared to be profitable, but what were the chances that it might never turn out to be a loser, and how should risk be analyzed and worked into the decision process? As the meeting was winding down, Maria and Robert were asked to start with the base case situation they had developed and then to discuss risk analysis, both in general terms and as it should be applied to the lite orange pineapple project.

To begin, Maria and Robert 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 the greatest uncertainty regarded unit sales and salvage value. Cost and sales price estimates were fairly well defined, but unit sales could vary widely, and the realized salvage value could be quite different from the $45,000 estimate. The sales price is also uncertain- However, companies in competitive markets typically set sales prices on the basis of competitors' prices, so, at least initially, they decided to treat the sales price as being fairly certain. However, the supply of agricultural products like oranges can rise or fall sharply due to favorable or unfavorable growing conditions, and that can lead to large price swings in both variable costs and product sales prices.

As estimated by the marketing staff, if product acceptance is "normal," then sales quantity during Year 1 would be 350,000 units: if acceptance is poor, then only 150.000 units would be sold (the price would be kept at the forecasted level); and if consumer response is strong, then the Year

1 sales volume would be 650,000 units. In all cases, the price would probably increase at the inflation rate (currently estimated to be 5 percent). Cash variable costs per unit would remain at $1.55 before adjusting for inflation. These costs would probably increase in each successive year at 2 percent rate. The production manager believes that the equipment's Year salvage value could be as low as zero and as high as $65,000. depending on the demand for such equipment after 4 years.

Maria and Robert also discussed the scenarios' probabilities with the marketing staff. After considerable debate, they finally agreed on a "guesstimate" of 25 percent probability of poor acceptance, a 50 percent probability of average acceptance, and 25 percent probability of excellent acceptance.

In addition, Orange Delight's executive committee requires that all sensitivity analyses consider changes in at least the following three variables: sales quantity, salvage value, and the

cost of capital. Company policy also mandates that each of the variables be allowed to deviate from its expected value by plus or minus 10 percent, 20 percent, and 30 percent in such an analysis.

Maria and Robert also discussed with Peter Brady, Orange Delight's director of capital budgeting, both the risk inherent in Orange Delight's average project and how the company typically adjusts for risk. Based on historical data, most of Orange Delight's projects have had coefficients of variation of NP in the range of 0.50 to 1.00, and Brady has been adding or subtracting 3 percentage points to the cost of capital for projects whose CVs lie outside that range to adjust for differential project risk.

The discussion with Brady raised another issue: Should the project's cost of capital be based on its stand-alone risk, on its risk as measured within the context of the firm's portfolio of assets (within-firm, or corporate, risk) or in a market risk context? Orange Delight's target capital structure) calls for 50 percent debt and 50 percent common equity, and the before-tax marginal cost of debt is currently 10 percent. Maria and Robert also determined that the T-bond rate, which they use as the risk-free rate, is 8.3 percent, and that the market risk premium is 6 percent. In addition, they estimated that the market beta for the project would be about 1.8

Since most members of Orange Delight's executive committee are unfamiliar with modern techniques of risk analysis, Maria and Robert decided to first discuss the types of risk that are normally considered in capital budgeting, and then consider the strengths and weaknesses of risk analysis. Next, they plan to discuss a comprehensive risk analysis including sensitivity analysis, scenario analysis, and an estimate of the project's differential risk-adjusted profitability. Last, they plan to discuss Monte Carlo simulation, and then provide a comparison of the various risk-analysis techniques.

QUESTIONS

a. What is sensitivity analysis?

Complete the sensitivity tables, assuming initially that the project has average risk. Also, develop new tables that show the sensitivity of NPV and the other variables to the initial variable cost and the cost of capital. Assume that each of these variables can deviate from its base case. or expected value, by plus or minus 10 percent, 20 percent, and 30 percent.

Prepare a sensitivity diagram/chart and discuss the results.

What are the primary weaknesses of sensitivity analysis? What are its primary advantages?

Complete the scenario analysis. What is the base case NPV? The best-case IRR? Use the worst-case, most likely, and best-case NPVs, and their probabilities of occurrence, to find the project's expected NPV, standard deviation, and coefficient of variation.

What are the primary advantages and disadvantages of scenario analysis?

What is Monte Carlo simulation, and what are the advantages and disadvantages of simulation vis--vis scenario analysis?

Would the lite orange pineapple project be classified as high risk, average risk, or low risk by your analysis thus far? (Hint: Consider the project's coefficient of variation of NPV What type of risk have you been measuring?)

Calculate the project's risk-adjusted NPV if the project was considered high risk. Should the project be accepted? What if it was judged to be a low-risk project?

Maria and Robert thought long and hard about the lite orange pineapple project's market beta. finally agreed to use 1.8 as their best estimate of the beta for the equity invested in the project.

On the basis of market risk, what is the project's required rate of return?

What is our recommendation? Should Orange Delight accept or reject the lite orange pineapple juice project?