Introduction

Canyon Buff Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Canyon Buff is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment.

The equipment must be purchased before the chemical production can begin. For tax purposes, the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that the asset can actually be used out into the indefinite future (i.e., the actual useful life is effectively infinite).

Canyon Buff anticipates that the sales will be $30,000,000 in the first year (Year 1). They expect that sales will initially grow at an annual rate of 6% until the end of sixth year (E.g., Year 6 sales = (1+6%)*Year 5 sales). After that, the sales will grow at the estimated 2% annual rate of inflation in perpetuity (E.g., Year 7 sales = (1+2%)*Year 6 sales).

The cost of goods sold is estimated to be 72% of sales for each year. The accounting department also estimates that at the introduction in Year 0, the new product's required initial net working capital will be $6,000,000. In future years (E.g., Year 1 and beyond) accounts receivable are expected to be 15% of the next year sales, inventory is expected to be 20% of the next years cost of goods sold and accounts payable are expected to be 15% of the next years cost of goods sold.

The selling, general and administrative expense is estimated to be $6,000,000 per year, but $1 million of this amount is the overhead expense that will be incurred even if the project is not accepted.

The market research to support the product was completed last month at a cost of $500,000 to be paid by the end of next year.

The annual interest expense tied to the project is $1,000,000. Canyon Buff has a cost of capital of 20% and faces a marginal tax rate of 30% and an average tax rate is 20%. Instructions I posted an incomplete Excel template for your analysis. You need to figure out how to construct the pro forma income statements and calculate the incremental unlevered net income. You should include ONLY the factors that will affect your capital budgeting decision. Revise the template if necessary. Note that your analysis should be set up so the assumptions that impact the cash flow estimates can be easily changed to identify the sensitivity of your calculations to these assumptions.

Questions

1. Use Excel to construct six-year pro forma income statements and calculate the incremental unlevered net income for the first six years.

When calculating incremental unlevered net income, should we include all the expenses mentioned in the case? If not, what expenses should we exclude and why? Clearly and concisely state your reasons in the cell E9 of the excel template (at most 2 sentences for each expense you exclude). If you just forecast the unlevered net income but dont given any explanations on why you exclude certain expenses

2. Calculate six-year projections for free cash flows. Remember to include cash flows from the income statement and depreciation, changes in net working capital, and capital expenditures. 3 Hint: You need to calculate the level of net working capital (NWC) and changes in NWC. Pay attention to the timing of NWC.

3. Canyon Buff expects that free cash flow will increase at a constant rate of 2%/year starting from Year 7 into the indefinite future (e.g., Year 7 FCF=(1+2%)*Year 6 FCF, Year 8 FCF= (1+2%)*Year 7 FCF, etc., but NOT Year 6 FCF=(1+2%)*Year 5 FCF). Calculate PV(terminal value that captures the value of future free cash flows in Year 6 and beyond) (Yes, Year 6 and beyond, NO typo here). That is, calculate the terminal value first, then find its value in Year 0 (today).

4. Determine the NPV of the project. Remember to net out any initial cash outflows (e.g., Year 0 FCFs). Divide your estimated PV(terminal value) in part 3. by NPV and put this ratio in cell B57.

5. Perform a sensitivity analysis by varying the four parameters as follows: Parameter Initial Assumption Worst Case Best Case Sales in Year 1 $30,000 $27,000 $33,000 NPV Sales Growth through Year 6 6% 0% 10% NPV Cost of Goods Sold (% of Sales) 72% 77% 67% NPV Cost of Capital 20% 23% 17%

6. Perform a scenario analysis by simultaneously varying the two parameters below: Sales Growth through Year 6 % Cost of Goods Sold NPV Scenario 1 (Baseline) 5% 71% Scenario 2 6% 72% Scenario 3 8% 73% Scenario 4 9% 74% Which scenario generates the highest NPV?