Nasco Heating Inc., a producer of heating equipment in Michigan, is currently evaluating the introduction of a new infrared space heater. Several of Nasco's competitors have already entered the quartz infrared market in response to the public's demand for heating devices that provide soft, moist, safe heat without reducing oxygen and humidity in the heated area. As a result, industry analysts predict high growth in the sales of infrared heaters in the years to come.Production facilities for the proposed project will be housed in a currently unused section of Nasco's plant; this section must be renovated upon commencement of the project at a cost of $350,000. Another local company has asked to lease this section of Nasco's plant for $120,000 a year for the next four years. The required production machinery costs $600,000; its shipping costis estimated to be $10,000, while its installation cost is $40,000. The machinery falls in the 5-year MACRS class, has an economic life of four years, and its salvage value is estimated to be $100,000 after four years of use. At that time however, Nasco plans to use the equipment for anew project.In addition, in each of the first two years of its life the project will require net working capital level equal to 5 percent of the infrared heater revenues; this net working capital must be available at the end of the year prior to sales. In year three net working capital will remain at its end-of-year two level, while it will totally vanish at the end of year four. Nasco expects to sell 400,000 units of the new heater in the first year of operations; thereafter unit sales are estimated to grow at a two percent annual rate. If the project is undertaken, production costs and selling price would be $48 and $55 per heater, respectively at current (t = 0) dollars; nevertheless, Nasco estimates that, beginning immediately, price will increase at the five percent inflation rate while production costs will increase at half that rate. Nasco's sales manager is concerned that the introduction of the infrared heater will cannibalizethe sales of the firm's existing technology (i.e., radiant and ceramic) heaters. She estimates that existing heater sales will decline by $2,000,000 in the first year, dropping by an additional two percent annually thereafter. As a result, Nasco's production manager estimates that existingheater production costs will decline by $500,000 in the first year, falling by an additional one percent annually thereafter. Nasco's weighted average cost of capital (WACC) is 12 percent and its tax rate is 21 percent.

1.You are in charge and expected to make a presentation to Nasco's top-management regarding the merits of the infrared heater project. Given the "base case" information provided above, estimate its cash flows over its life and provide measures of the project's desirability or lack thereof. (Explain in detail cash flow calculations for years 0 and 4.)

2.Once you have presented the above calculations, one of the firm's VPs asks whether you used the project's real cash flows discounted at a real rate, or its nominal cash flows discounted at a nominal rate. Further, this VP asks you to demonstrate that either approach provides the same present value for the cash flow of year 4. 3.From past experience, you know that Nasco's management is interested in the different scenarios under which the project's NPV will be zero; i.e., the project will break even in terms of NPV. To be prepared, you would like to consider the following scenarios:

i.All else the same, at what year 0 price per heater would the project break even?

ii.All else the same, what is the sales volume (in heaters) in each of the next four years for which the project will break even?

4.You also want to prepare calculations for the following alternative scenarios regarding the impact of inflation on the price and production cost per heater: i.All else the same, what is the project's NPV if production costs increase annually at the 5% inflation rate instead of half of that rate?ii.All else the same, what is the project's NPV if production costs increase annually at the 5% inflation rate but the priceper heater increases at half that rate annually?

5.You also expect management to inquire about the impact of t = 4 machinery salvage value, t = 1 sales in heaters, and the discount rateon your calculations. Perform sensitivity analysis for the project's NPV with respect to each of these three input variables assuming each one deviates from its base case level by 10%, 20%, 30%. Tabulate and plot your results and describe your findings and their implications.

6.Based on your calculations for 5 above, management appears to be concerned with the base case (or average) sales of 400,000 heaters at t = 1 and asks for more detailed information regarding possible sales scenarios. The sales manager is present in the meeting and provides the following information:Demand for infrared heaters Low Average High Sales in heaters 100,000 400,000 700,000 Probability 0.25 0.50 0.25 Provide NPV calculations for the project under these three scenarios and address management's concerns.

7.Nasco's CFO is also present at the meeting and wonders whether the discounting rate for the infrared heater project will be the firm's 12 percent WACC. He explains that he checked the infrared heater projects undertaken by Nasco's competitors and found that such projects have used a discounting rate which, on average, exceeds the firm's WACC by 4.5 percent, suggesting higher risk for such projects. All else the same, how would this information impact your calculations for the base case NPV?

8.CFO asks you to provide a report to justify whether Nasco should invest in the infrared heater project or not.