Part (E) (2 points) Assume that you are confident about the estimates of all the variables that affect the cash flows except unit sales. If product acceptance is poor, sales would be only 75,000 units a year, while a strong consumer response would produce sales of 125,000 units. In either case, cash costs would still amount to 60% of revenues. You believe that there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case). 1. What is the worst-case NPV? The best-case NPV? 2. Use the worst-case, most likely case (or base-case), and best-case NPVs with their probabilities of occurrence, to find the project's expected NPV, standard deviation, and coefficient of variation. Table 2: Allied's Lemon Juice Project Considering 5% Inflation $ L Investment Outlays Equipment cost Installation CAPEX (200,000) 140,000) 240,000) $ Increase in inventory Increase in Account Payable ANOWC 25.000) 5,000 20,000) $ $ 100.000 2.100 $ 210,000 100.000 2.205 220.500 $ 100.000 2.315 231,925 $ 100.000 2.431 2 41.101 Il Project Operating Cash Flows Unit sales Price per unit Total revenues Operating costs (wo depr) Depreciation Total costs EBIT (Operating income) Taxes on operating income EBIT (1 - T) - Aafter tax operating income Add back depreciation EBIT (1 - T). DEP . Terminal Year Cash Flows Salvage value Tax on salvage value After-tax salvage value Recovery of NOWC Project Free Cash Flows - EBIT(1-T) + DEP-CAPEX - ANOWC 3 260.000) 389.040 X 1 19,090 Part () (2 points) Assume that Allied's average project has a coefficient of variation (CV) in the range of 1.25 to 1.75. Would the lemon juice project be classified as high risk, average risk, or low risk? What type of risk is being measured here? Part (G) (3 points) Assume that Allied's average project has a coefficient of variation (CV) in the range of 1.25 to 1.75. Allied typically adds or subtracts 3% to its WACC to adjust for risk. After adjusting for risk, should the lemon juice project be accepted? Explain. Part (H) (2 points) In recent months, Allied's group has begun to focus on real option analysis 1. What is real option analysis? 2. What are some examples of projects with embedded real options? Allied Food Products is considering expanding into the fruit juice business with a new fresh lemon juice product. Assume that you were recently hired as assistant to the director of capital budgeting, and you must evaluate the new project. The lemon juice would be produced in an unused building adjacent to Allied's Fort Myers plant; Allied owns the building, which is fully depreciated. The required equipment would cost $200,000, plus an additional $40,000 for shipping and installation. In addition, inventories would rise by $25,000, while accounts payable would increase by $5,000. All of these costs would be incurred att0. By a special ruling, the machinery could be depreciated under the MACRS system as 4. year property. The applicable depreciation rates are 45%, 35%, 15%, and 5%. The project is expected to operate for 4 years, at which time it will be terminated. The cash inflows are assumed to begin 1 year after the project is undertaken (t1), and to continue out to t4. At the end of the project's life ( 4). the equipment is expected to have a salvage value of $25,000. Unit sales are expected to total 100.000 units per year, and the expected sales price is $2.00 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Allied's tax rate is 21%, and its WACC is 10%. Tentatively, the lemon juice project is assumed to be of equal risk to Allied's other assets. You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected. To guide you in your analysis, your boss gave you the following set of: Table 1: Allied's Lemon Juice Project L Investment Outlys Equipment cost Shipping and installation CAPEX Increase in inventory Increase in Accounts Payable ANOWC $ 2.00 100,000 x 2.00 X $ 200,000 120,000 x I. Project Operating Cash Flows Un sales Price per unit Total revenues Operating costs (wo depm) Depreciation Total costs EBIT (Operating income) Taxes on operating Income EBIT (1 - 1) - After Tax operating income Add back depreciation EBIT (1-T). DEP 35.000 12.000 228.000 204.000 $ 44,000 X 15,880) 14,280 X 34,780 35.000 108.000 42.000 $ 650/20 III. Project Termination Cash Flows Salvage value Tax on salvage value After-tax salvage value ANOWC - Recovery of NOWC Project Free Cash Flows EBIT(4-T). DEP-CAPEX - ANOWC $25,000 15.250 19.750 $20,000 105,470 35280.000 x Part (B) Calculate the project's NPV, IRR, MIRR, and payback. Do these indicators suggest that the project should be accepted? Explain. Part (C) 1. What is sensitivity analysis? 2. How would you perform a sensitivity analysis on the unit sales. salvage value, and WACC for the project? Assume that each of these variables deviates from its base case, or expected value by plus or minus 10%, 20%, and 30%. Explain how you would calculate the NPV, IRR, MIRR, and payback for each case. 3. What is the primary weakness of sensitivity analysis? What are its primary advantages? Part (D) Assume that inflation is expected to average 5% over the next 4 years and that this expectation is reflected in the WACC. Moreover, inflation is expected to increase revenues and variable costs by this same 5%. Does it appear that inflation has been dealt with properly in the initial analysis to this point? If not, what should be done and how would the required adjustment affect the decision? Part (E) (2 points) Assume that you are confident about the estimates of all the variables that affect the cash flows except unit sales. If product acceptance is poor, sales would be only 75,000 units a year, while a strong consumer response would produce sales of 125,000 units. In either case, cash costs would still amount to 60% of revenues. You believe that there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case). 1. What is the worst-case NPV? The best-case NPV? 2. Use the worst-case, most likely case (or base-case), and best-case NPVs with their probabilities of occurrence, to find the project's expected NPV, standard deviation, and coefficient of variation. Table 2: Allied's Lemon Juice Project Considering 5% Inflation $ L Investment Outlays Equipment cost Installation CAPEX (200,000) 140,000) 240,000) $ Increase in inventory Increase in Account Payable ANOWC 25.000) 5,000 20,000) $ $ 100.000 2.100 $ 210,000 100.000 2.205 220.500 $ 100.000 2.315 231,925 $ 100.000 2.431 2 41.101 Il Project Operating Cash Flows Unit sales Price per unit Total revenues Operating costs (wo depr) Depreciation Total costs EBIT (Operating income) Taxes on operating income EBIT (1 - T) - Aafter tax operating income Add back depreciation EBIT (1 - T). DEP . Terminal Year Cash Flows Salvage value Tax on salvage value After-tax salvage value Recovery of NOWC Project Free Cash Flows - EBIT(1-T) + DEP-CAPEX - ANOWC 3 260.000) 389.040 X 1 19,090 Part () (2 points) Assume that Allied's average project has a coefficient of variation (CV) in the range of 1.25 to 1.75. Would the lemon juice project be classified as high risk, average risk, or low risk? What type of risk is being measured here? Part (G) (3 points) Assume that Allied's average project has a coefficient of variation (CV) in the range of 1.25 to 1.75. Allied typically adds or subtracts 3% to its WACC to adjust for risk. After adjusting for risk, should the lemon juice project be accepted? Explain. Part (H) (2 points) In recent months, Allied's group has begun to focus on real option analysis 1. What is real option analysis? 2. What are some examples of projects with embedded real options? Allied Food Products is considering expanding into the fruit juice business with a new fresh lemon juice product. Assume that you were recently hired as assistant to the director of capital budgeting, and you must evaluate the new project. The lemon juice would be produced in an unused building adjacent to Allied's Fort Myers plant; Allied owns the building, which is fully depreciated. The required equipment would cost $200,000, plus an additional $40,000 for shipping and installation. In addition, inventories would rise by $25,000, while accounts payable would increase by $5,000. All of these costs would be incurred att0. By a special ruling, the machinery could be depreciated under the MACRS system as 4. year property. The applicable depreciation rates are 45%, 35%, 15%, and 5%. The project is expected to operate for 4 years, at which time it will be terminated. The cash inflows are assumed to begin 1 year after the project is undertaken (t1), and to continue out to t4. At the end of the project's life ( 4). the equipment is expected to have a salvage value of $25,000. Unit sales are expected to total 100.000 units per year, and the expected sales price is $2.00 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Allied's tax rate is 21%, and its WACC is 10%. Tentatively, the lemon juice project is assumed to be of equal risk to Allied's other assets. You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected. To guide you in your analysis, your boss gave you the following set of: Table 1: Allied's Lemon Juice Project L Investment Outlys Equipment cost Shipping and installation CAPEX Increase in inventory Increase in Accounts Payable ANOWC $ 2.00 100,000 x 2.00 X $ 200,000 120,000 x I. Project Operating Cash Flows Un sales Price per unit Total revenues Operating costs (wo depm) Depreciation Total costs EBIT (Operating income) Taxes on operating Income EBIT (1 - 1) - After Tax operating income Add back depreciation EBIT (1-T). DEP 35.000 12.000 228.000 204.000 $ 44,000 X 15,880) 14,280 X 34,780 35.000 108.000 42.000 $ 650/20 III. Project Termination Cash Flows Salvage value Tax on salvage value After-tax salvage value ANOWC - Recovery of NOWC Project Free Cash Flows EBIT(4-T). DEP-CAPEX - ANOWC $25,000 15.250 19.750 $20,000 105,470 35280.000 x Part (B) Calculate the project's NPV, IRR, MIRR, and payback. Do these indicators suggest that the project should be accepted? Explain. Part (C) 1. What is sensitivity analysis? 2. How would you perform a sensitivity analysis on the unit sales. salvage value, and WACC for the project? Assume that each of these variables deviates from its base case, or expected value by plus or minus 10%, 20%, and 30%. Explain how you would calculate the NPV, IRR, MIRR, and payback for each case. 3. What is the primary weakness of sensitivity analysis? What are its primary advantages? Part (D) Assume that inflation is expected to average 5% over the next 4 years and that this expectation is reflected in the WACC. Moreover, inflation is expected to increase revenues and variable costs by this same 5%. Does it appear that inflation has been dealt with properly in the initial analysis to this point? If not, what should be done and how would the required adjustment affect the decision