RISK ANALYSIS, REAL OPTIONS AND CAPITAL BUDGETING

Hardwick Corporation manufactures fine furniture for residential and industrial use. The demand for the company$$s products has increased tremendously in the past three years. As a result, the company wants to expand its production facility by building a warehouse facility in either Cleveland, Ohio or Alexandria, VA$.$ The company is considering a $10-$year expansion project that requires an initial investment of $$2\mathrm{.}0$ million for the Ohio project and $$2\mathrm{.}55$ million for the Virginia project. The variable cost of making each piece of furniture is $$350.$ The price per piece of furniture depends on the size, weight, and quality of wood used but the average price is $$1,350.$ The fixed cost of the project is $$2$ million. It is the accounting policy of the company to depreciate fixed assets using straight$-$line method over the life of the project, after which the assets will be worthless. The company faces a tax rate of $35\%.$ The finance department of the company has prepared the cash flows from the projected sales and expenses figures for the two projects.

Exhibit $1$: The expected cash flows in US$ from the project in Ohio and Virginia.

Year

Cashflow $($Ohio$)$

Cash flow $($VA$)$

$0$

$(2,000,000)$

$(2,550,000)$

$1$

$450,000$

$350,000$

$2$

$558,000$

$185,000$

$3$

$562,000$

$205,000$

$4$

$587,000$

$300,000$

$5$

$600,000$

$370,000$

$6$

$625,000$

$590,000$

$7$

$630,000$

$500,000$

$8$

$685,000$

$483,000$

$9$

$690,000$

$480,000$

$10$

$692,000$

$620,000$

The company$$s policy is to select projects using NPV technique and IRR. The cost of capital is $12\%$ for the Ohio project and $10\%$ for VA project.

$1.$ The Board of Directors of the company wants you to make a PowerPoint Presentation on the evaluation of the project. In the presentation the board wants you to do the following:

a$.$ Calculate the payback period $($PBP$)$ for the two projects.

b$.$ Calculate the profitability Index $($PI$)$ for the two projects.

c$.$ Calculate the Internal Rate of Return $($IRR$)$ for the two projects.

d$.$ Calculate the Net Present Value $($NPV$)$ for the two projects.

e$.$ Use the NPV technique to recommend which investment project it should accept, assuming the cost of capital of financing the Ohio project is $12\%$ and $10\%$ for the Virginia project?

$2.$ Lok, a board member knows how bad forecast of cash flows can ruin capital budgeting decisions. Lok$$s question is$$ If the cost of capital changes from $12\%$ to $13\%$ for Ohio project and remains the same for the VA project, does the company have to pursue the project?$$

$3.$ The board wants you to qualitatively analyze the risk of the project using sensitivity analysis and Monte Carlo simulation.

a$.$ Explain in the presentation to the board how the two risk analysis models can be used to analyze risk of the project $($no calculation is required$).$

$4.$ The finance team has estimated the fixed costs $($including depreciation$)$ of the Ohio project to be $$2$ million, average sales price is $$1,350,$ and the variable cost is $$350,$ giving a contribution margin of $$1,000.$ What is the accounting profit break$-$even quantity for this project?

$5.$ The Board of Directors wants to know the likely effect of the capital budgeting project on its stock price before it can approve it$.$ What is the likely effect of the Ohio project on the company$$s stock price? $($The likely effect is increase, decrease, no change, or not sure$).$ Choose one and explain why.