P 12-3 Breakeven cash inflows and risk

Boardman Gases and Chemicals is a supplier of highly purified gases to semiconductor manufacturers. A large chip producer has asked Boardman to build a new gas production facility close to an existing semiconductor plant. Once the new gas plant is inplace, Boardman will be the exclusive supplier for that semiconductor fabrication plant for the subsequent 10 years. Boardman is considering one of two plant designs. The first is Boardman's "standard" plant which will cost $38.3 million to build. The second is for a"custom" plant which will cost $53.8 million to build. The custom plant will allow Boardman to produce the highly specialized gases required for an emergency semiconductor manufacturing process. Boardman estimates that its client will order $12.9 million of product per year if the standard plant isconstructed, but if the custom design is put inplace, Boardman expects to sell $16.9 million worth of product annually to its client. Boardman has enough money to build either type ofplant, and, in the absence of riskdifferences, accepts the project with the highest NPV. The cost of capital is 17.4%.

a.Find the NPV for each project. Are the projectsacceptable?

b.Find the breakeven cash inflow for each project.

c.The firm has estimated the probabilities of achieving various ranges of cash inflows for the twoprojects, as shown in the table. What is the probability that each project will achieve the breakeven cash inflow found in part (b)?

d. Which project is morerisky? Which project has the potentially higherNPV? Discuss therisk-return trade-offs of the two projects.

e. If the firm wished to minimize losses(that is, NPV<$0), which project would yourecommend? Which would you recommend if the goal was achieving a higherNPV?

Probability of achieving cash inflow in given range

Range of cash inflow($ millions) Standard Plant Custom Plant

$0 to$5 0 % 5 %

$5 to$8 10 10

$8 to$11 60 15

$11 to$14 25 25

$14 to$17 5 20

$17 to$20 0 15

Above$20 0 10