PLEASE REFER TO THE INFORMATION IN THE ATTACHED PHOTO ABOVE TO ANSWER THESE QUESTIONS. A SPREADSHEET SHOULD BE USED AND INCLUDED IN THE ANSWERS. ALSO, EXPLAIN HOW YOU GOT YOUR ANSWER.
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What is the year 0 net investment outlay on this project? Explain.
a. What is the expected nonoperating terminal cash flow on this project in year 6? Explain.
b. Estimate the project's operating cash flows. Assume the sales price will increase by a 3.5% inflation rate beginning from year 0 (from the initial sales price estimate) and cash operating costs (variable per unit and fixed) will increase by 2.5% annually from the initial cost estimate, also beginning from year 0. Assume no other cash flows (net working capital, or salvage values) are affected by inflation. Of course, lease payments are impacted by inflation but only to the extent of the previously mentioned 2.0% escalation clause. What are the project's NPV, IRR, MIRR? Use 14% for the required rate of return. Explain.
c. To the closest penny, what would the year 0 unit price have to be in order for the project to just break even, that is, to force NPV = $0? Explain.
d. What level of annual unit sales would cause the project to just break even? Explain.
e. What level of sales price increase (the price inflation rate) would cause the project to just break even? Explain.
f. What is the projects NPV under the following circumstances:
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Unit sales price and cash operating costs (variable per unit and fixed) increase at the same rate, 3.5% per year? Explain.
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Unit sales price rises by only 2.5%, but unit variable cash operating costs (variable per unit and fixed) increase by 3.5% per year? Explain.
g. Complete a sensitivity analysis considering the following 7 variables:
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unit sales,
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unit sales price,
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unit variable cash operating costs,
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fixed cash operating costs,
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salvage value,
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annual sales price increase (the price inflation rate),
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annual operating costs increase (this is the inflation rate for both variable costs per unit and fixed costs)
Company policy mandates that each of the variables be allowed to deviate from the expected or base value by plus and minus 5%, 10%, 15%, 20%, and 25% in such an analysis. Produce 7 tables, one for each of the above variables, showing the results of your sensitivity analysis upon NPV. These sensitivity tables should be based upon the same basic spreadsheet produced to answer question 1b.
h. What is the best case NPV? What is the worst case NPV? This should be based upon the description of the best case and worst case in the provided information in the photo. You should include 2 spreadsheets one for the best case and one for the worst case. Make the necessary changes in the basic spreadsheet used to answer question 1b in order to answer this question. Explain.
i. Complete a Monte Carlo Simulation with 2,000 iterations. From the distribution of NPVs produced, compute the expected NPV, standard deviation, coefficient of variation and the probability the NPV is greater than 0. Use the following assumptions to perform the Monte Carlo simulation:
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Annual unit sales quantity is distributed normally with an expected value of 10 thousand sentinels and a 95% confidence interval projection of approximately 7 thousand to 13 thousand sentinels.
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The unit sales price is distributed normally with an expected value of $5,000 and a 95% confidence interval projection of approximately $4,500 to $5,500.
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Unit variable operating cost is distributed normally with an expected value of $2,800 and a 95% confidence interval projection of approximately $2,750 to $2,850.
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Unit sales price inflation rate is distributed normally with an expected value of 3.5% and a 95% confidence interval of approximately 2.0% to 5.0%.
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Cash operating costs (both variable and fixed) inflation rate is distributed normally with an expected value of 2.5% and a 95% confidence interval of approximately 1.5% to 3.5%.
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Salvage value is distributed uniformly with a bottom limit of $2 million and a top limit of $14 million.
*A spreadsheet should be used and included to specifically answer this question. Be sure to use and show the basic spreadsheet that was used to answer question b adapted to perform and show the results of the Monte Carlo simulation. Descriptive statistics regarding the NPV should include: Mean (expected value), Median, Maximum value, Minimum Value, Standard Deviation and Coefficient of Variation.
j. Based upon the results of your Monte Carlo simulation analysis is this a high risk or a low risk project? Based upon your answer and CFO Mayos past practice, what is the risk-adjusted NPV (not expected NPV, but just a risk-adjusted NPV)? A spreadsheet should be used and included to specifically answer this question. Be sure to use the same basic spreadsheet you produced to answer question 1b.
k. What is your recommendation? Should Trujillos Security Solutions, Inc. accept or reject this project? Base your answer and discussion upon the expected NPV, IRR, and MIRR, and all the other analysis you performed in answering questions 1b 1j. You should explicitly discuss how each of these answers inform and impact your decision to accept or reject this project. Do not make any assumptions that are inconsistent with information provided.
6 years
Trujillo's Security Solutions, Inc. is a successful, rapidly growing firm benefitting from the swift growth in technology. Gibran Trujillo, the corporate founder, is considering a new path-breaking product. The R&D arm of the company, led by Kristen Espino, has recently developed a high-tech, artificial intelligence infused security guard for both home and business use. It is essentially a robot with a very high level of artificial intelligence. It can roam the premises of a home or business, converse with humans and properly notify the homeowner, business owner or police as circumstances determine what is appropriate. Gibran and Kristen have decided to call each robot a sentinel. If the company decides to go forward with this project, an assembly facility will be located in buildings leased for $2.6 million annually. This lease payment is tax-deductible, paid at the beginning of each year, and has an escalation clause causing the lease payment to increase 2.0% annually over the life of the project. Thus, the lease payment at the beginning of year 1 will be $2.6 million and it will then increase by 2.0% annually thereafter. Equipment for the facility will cost $33.5 million including delivery and installation. Net working capital needs will be $4.4 million immediately to support the facility. Assume the networking capital will not be needed and returned at the end of the project's six-year economic life. Equipment depreciation will be according to MACRS 5-year asset class (20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76% respectively for years one through six). The equipment is expected to have a salvage value of 58 million after 6 years of use. Management expects to produce and sell 10 thousands sentinels annually at an initial price of $5,000 each. Fixed cash operating costs (not including depreciation and lease payment) are estimated to be $8.3 million annually and variable cash operating costs are estimated at $2,800 per sentinel. Trujillo's federal-plus-state effective tax rate is 23%. Your task is to analyze this project. You must recommend acceptance or rejection and evaluate the project's acceptability using the net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR) criteria. Trujillo's weighted average cost of capital and thus the project's required rate of return is 14%. Sam Mayo, the CFO, wondered whether it would be appropriate to assume neutral inflation equal to the 3.5% expected general rate of inflation, and if not, how sensitive the results would be to alternative assumptions of differential inflation impacts on revenues and costs. Sam expects these and other questions to be raised when you present your recommendations to the Executive Committee. In addition to the basic capital budgeting analysis, Sam would like you to perform a risk analysis on the new capital budgeting project. The project appears to be profitable, but what are the chances that it might nevertheless turn out to be a loser, and how should risk be analyzed and worked into the decision process? You met with Emily Lee of engineering and Salem Tigabu from marketing to get a feel for the uncertainties involved in the cash flow estimates. After several sessions, you concluded the greatest uncertainty involved unit sales, variable cash operating costs and salvage value. Unit sales and the variable cost of production could vary widely, and the realized salvage value could be quite different from the estimates. As estimated by Salem's marketing staff, if product acceptance is "normal" (base case), then sales quantity during the life of the project would be 10 thousand sentinels annually. If acceptance is poor" (worst case), then only 7 thousand sentinels would be sold annually during the life of the project; and if consumer response is "strong" (best case), then the sales volume would be 13 thousand sentinels annually during the life of the project. In any case, the price is expected to be kept at the forecasted level. In all cases, the price would probably increase in each successive year at the inflation rate (currently estimated to be 3.5%), while variable cash operating costs per unit and fixed cash operating costs would both increase in each successive year at a 2.5% rate. As estimated by Emily's staff, the equipment's salvage value at the end of 7 years could be as low as $2 million and as high as $14 million. If product acceptance is low (worst case), the equipment's salvage value will likely be about $2 million. If product acceptance is high (best case), the equipment's salvage value will likely be about $14 million. Trujillo's Security Solutions' Executive Committee requires that all sensitivity analyses consider changes in at least the following variables: unit sales, unit sales price, unit variable cash operating costs, fixed cash operating costs, and salvage value. Remember the lease payment will increase by 2.0% annually as required by the lease contract regardless of actual inflation. Company policy also mandates that each of the variables be allowed to deviate from its expected value by plus or minus 5%, 10%, 15%, 20%, and 25% in such an analysis. In the past, Sam had scenario analyses performed on proposed capital budgeting projects in order to measure project risk with a coefficient of variation. He is considering the use of Monte Carlo simulations to estimate the coefficient of variation on future projects. From past experience, Sam considers projects with coefficients of variation between 0.25 and 0.75 to be average risk projects. Projects outside this range would have the required rate of return adjusted up by 4% for high-risk projects and 4% down for low-risk projects. You have been hired to perform the basic capital budgeting analysis and then to introduce the concepts of inflation and risk into the analysis. Sam plans to include a comprehensive risk analysis. Your task is to help him perform these analyses and to write up a report so he can make a recommendation to the Executive Committee. Trujillo's Security Solutions, Inc. is a successful, rapidly growing firm benefitting from the swift growth in technology. Gibran Trujillo, the corporate founder, is considering a new path-breaking product. The R&D arm of the company, led by Kristen Espino, has recently developed a high-tech, artificial intelligence infused security guard for both home and business use. It is essentially a robot with a very high level of artificial intelligence. It can roam the premises of a home or business, converse with humans and properly notify the homeowner, business owner or police as circumstances determine what is appropriate. Gibran and Kristen have decided to call each robot a sentinel. If the company decides to go forward with this project, an assembly facility will be located in buildings leased for $2.6 million annually. This lease payment is tax-deductible, paid at the beginning of each year, and has an escalation clause causing the lease payment to increase 2.0% annually over the life of the project. Thus, the lease payment at the beginning of year 1 will be $2.6 million and it will then increase by 2.0% annually thereafter. Equipment for the facility will cost $33.5 million including delivery and installation. Net working capital needs will be $4.4 million immediately to support the facility. Assume the networking capital will not be needed and returned at the end of the project's six-year economic life. Equipment depreciation will be according to MACRS 5-year asset class (20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76% respectively for years one through six). The equipment is expected to have a salvage value of 58 million after 6 years of use. Management expects to produce and sell 10 thousands sentinels annually at an initial price of $5,000 each. Fixed cash operating costs (not including depreciation and lease payment) are estimated to be $8.3 million annually and variable cash operating costs are estimated at $2,800 per sentinel. Trujillo's federal-plus-state effective tax rate is 23%. Your task is to analyze this project. You must recommend acceptance or rejection and evaluate the project's acceptability using the net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR) criteria. Trujillo's weighted average cost of capital and thus the project's required rate of return is 14%. Sam Mayo, the CFO, wondered whether it would be appropriate to assume neutral inflation equal to the 3.5% expected general rate of inflation, and if not, how sensitive the results would be to alternative assumptions of differential inflation impacts on revenues and costs. Sam expects these and other questions to be raised when you present your recommendations to the Executive Committee. In addition to the basic capital budgeting analysis, Sam would like you to perform a risk analysis on the new capital budgeting project. The project appears to be profitable, but what are the chances that it might nevertheless turn out to be a loser, and how should risk be analyzed and worked into the decision process? You met with Emily Lee of engineering and Salem Tigabu from marketing to get a feel for the uncertainties involved in the cash flow estimates. After several sessions, you concluded the greatest uncertainty involved unit sales, variable cash operating costs and salvage value. Unit sales and the variable cost of production could vary widely, and the realized salvage value could be quite different from the estimates. As estimated by Salem's marketing staff, if product acceptance is "normal" (base case), then sales quantity during the life of the project would be 10 thousand sentinels annually. If acceptance is poor" (worst case), then only 7 thousand sentinels would be sold annually during the life of the project; and if consumer response is "strong" (best case), then the sales volume would be 13 thousand sentinels annually during the life of the project. In any case, the price is expected to be kept at the forecasted level. In all cases, the price would probably increase in each successive year at the inflation rate (currently estimated to be 3.5%), while variable cash operating costs per unit and fixed cash operating costs would both increase in each successive year at a 2.5% rate. As estimated by Emily's staff, the equipment's salvage value at the end of 7 years could be as low as $2 million and as high as $14 million. If product acceptance is low (worst case), the equipment's salvage value will likely be about $2 million. If product acceptance is high (best case), the equipment's salvage value will likely be about $14 million. Trujillo's Security Solutions' Executive Committee requires that all sensitivity analyses consider changes in at least the following variables: unit sales, unit sales price, unit variable cash operating costs, fixed cash operating costs, and salvage value. Remember the lease payment will increase by 2.0% annually as required by the lease contract regardless of actual inflation. Company policy also mandates that each of the variables be allowed to deviate from its expected value by plus or minus 5%, 10%, 15%, 20%, and 25% in such an analysis. In the past, Sam had scenario analyses performed on proposed capital budgeting projects in order to measure project risk with a coefficient of variation. He is considering the use of Monte Carlo simulations to estimate the coefficient of variation on future projects. From past experience, Sam considers projects with coefficients of variation between 0.25 and 0.75 to be average risk projects. Projects outside this range would have the required rate of return adjusted up by 4% for high-risk projects and 4% down for low-risk projects. You have been hired to perform the basic capital budgeting analysis and then to introduce the concepts of inflation and risk into the analysis. Sam plans to include a comprehensive risk analysis. Your task is to help him perform these analyses and to write up a report so he can make a recommendation to the Executive Committee
