Northern Lights, Inc., a producer of electric bulbs in Michigan, is currently evaluating the introduction of a line of more efficient bulbs. Most of its competitors have already entered and to remain competitive management believes it is necessary for Northern Lights to also enter the efficient bulbs market. Industry analysts predict steady growth in the sales of efficient bulbs in the years to come.

Production facilities for the proposed project will be housed in a currently unused section of Northern Lights plant; this section was renovated last year at a cost of $150,000 and is currently leased to a local company for $20,000 a year. The lease is scheduled to expire in five years from today; however, if Northern Lights breaks the lease now, it must pay $15,000 to the lessee. The machinery required for the production of the new bulbs costs $470,000; its shipping cost is estimated to be $10,000, while its installation cost is $40,000. The machinery falls in the 3-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. In addition, Northern Lights must increase inventories by $10,000 at the time of the initial investment in the machinery. Thereafter, inventories should be three percent of next years revenues over the life of the project.

Northern Lights expects to sell 400,000 of the new bulbs in the first year of operations; thereafter unit sales are estimated to grow at a two percent annual rate. If the project is undertaken, average production cost and selling price would be $1.50 and $2.00 per bulb, respectively at current (t = 0) dollars; nevertheless, Northern Lights estimates that price will increase at the five percent inflation rate while production costs will increase by only two and a half percent annually beginning immediately.

Northern Lights sales manager is concerned that the introduction of the efficient bulbs will cannibalize the sales of the firms regular bulbs. She estimates that regular bulb sales will decline by $40,000 in the first year, dropping by an additional one and a half percent annually thereafter. As a result, Northern Lights production manager estimates that regular bulbs production costs will decline by $20,000 in the first year, falling by an additional one percent annually thereafter.

Northern Lights debt-to-value ratio is .50. The before-tax yield on Northern Lights long-term debt is 10%. The firms equity beta is 2 and its marginal tax rate is 40%. Analysts consensus for the market return is 7.5% and the one-year yield on T-bills is 1% over the life of the project.

1. You are in charge and expected to make a presentation to Northern Lights top- management regarding the merits of the efficient bulbs project. Given the base case information provided above, estimate the net cash flows over its life and provide measures of the projects desirability or lack thereof. (Explain in detail your calculations for years 0 and 4.)

2. Once you have presented the above calculations, one of the firms VPs asks whether you used real cash flows discounted at a real rate, or 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.

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3. From past experience, you know that Northern Lights management is interested in the different scenarios under which the projects 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 bulb would the project break even? ii. All else the same, at what year 0 production cost per bulb would the project break

even? iii. All else the same, what is the sales volume (in bulbs) 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 bulb:

All else the same, what is the projects NPV if production costs increase annually

at the 5% inflation rate instead of the 2.5% rate?

All else the same, what is the projects NPV if production costs increase annually

at the 5% inflation rate but the price per bulb increases 2.5% annually?

5. You also expect management to inquire about the impact of t = 4 machinery salvage value, t = 1 sales in bulbs, and the discount rate on your calculations. Perform sensitivity analysis for the projects NPV with respect to 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 sales of 400,000 bulbs at t = 1 and asks you to provide more detailed information regarding the possible sales scenarios. The sales manager is present in the meeting and provides the following information:

Demand for efficient bulbs	Low	Average	High
Sales in bulbs	200,000	400,000	600,000
Probability	0.25	0.50	0.25

Provide NPV calculations for the project under these three scenarios and address managements concerns.

7. Northern Lights CFO is also present at the meeting and wonders whether the discounting rate for the efficient bulbs project will be the firms WACC. He suggests that he checked the betas of efficient bulb projects undertaken by Northern Lights competitors and found that such projects have a beta which is 50% higher than the beta of the firms themselves suggesting higher market risk for such projects. All else the same, how would this information impact your calculations for the base case NPV?

8. After your presentation, the CFO asks you to provide a written report as of whether Northern Lights should invest in the efficient bulbs project or not. Be specific and justify your recommendation.