James River Paper is considering to build a new lumber plant that uses some recently developed technology that will greatly reduce production costs. James River must buy land for the plant and construct it. You have been employed as a consultant for James Rivers VP of Finance to help with this decision.

You estimate that the acquisition cost of the land is $10 million, assuming that you acquire the required land immediately. Construction of the factory building and installation of the equipment is expected to take two years and cost $35,000,000 (payable $15 million today, and $10 million at each of year 1 and 2). The cost of the buildings and equipment will be depreciated on a straight-line basis over 20 years. The plant starts to operate and generate sales revenue from year 3. Depreciation will also begin in year 3. Estimated annual sales are 15,000,000 square feet of lumber in each of the first ten years the plant operates. You expect that the quantity produced will decline by 3% per year beginning in the eleventh year of operation. The price of lumber today is $13.65/sq. foot. James River faces a 35% marginal tax rate.

The engineering staff has provided you with some preliminary cost estimates for the project. Fixed costs to run the plant for one year will be $25,000,000 when the plant starts operation. According to the engineers, additional estimated costs of production are expected to be $14 per square foot once the plant is operating $12.75 of this cost is actually incremental to firm, and $1.25 of this estimate is allocated overhead (i.e., costs that would be incurred by James River regardless of whether the new plant is built but which have been assigned to the proposed new plant). In addition, James River spent $3 million over the past year fine tuning the new technology after it bought the domestic rights to the technology from a Dutch firm two years ago for $1 million. Prices in the economy are expected to increase at 3.5% per year indefinitely. This figure affects output prices, variable input costs, and the fixed costs of operating the plant. Fixed costs are independent of the level of output but are not constant across time.

At the end of year 2, accounts payable for James River is expected to increase by $2 million, and inventory is expected to increase by $4 million. These additional amounts will allow James River to begin operation of the plant during year 3. Once the project begins full scale operations, net working capital (cash balance + accounts receivable + inventory accounts payable and other payables) is expected to have a stable relationship with yearly sales that call for net working capital to be 4% of sales in each year. James River expects to recover the remaining working capital at the end of the project in the year after operation ceases.

Additional capital expenditures of $5 million will be necessary in the 5^th, 10^th, and 15^th years of operation for this project ($5 million in each of these three years). This additional capital expenditure will be depreciated on a 5-year straight-line basis. Depreciation for these assets will begin in the first year after the expenditures. While the value of the land and buildings at the end of the projects life is highly uncertain, the VP of Finance expects that the value should be at least the original $10 million invested in the land adjusted for inflation over the life of the project. Assume sale of the project will occur in the year after the last year of operation. The required return for this project is 9%.

Prepare a project analysis for the Vice President of Finance of James River Paper under the above instructions. Calculate the NPV and internal rate of return. What is your recommendation for this project? Discuss.

In discussion with the VP and her staff, you have determined that there is concern about the assumptions regarding the level of incremental variable costs. To address these concerns, find the breakeven level of incremental variable fixed costs per unit that makes the NPV=0. How does this figure make you feel about the perceived value of the project? Explain.