Section 1: Capital Budgeting

Keener Clothiers Inc. is considering investing $2m in an automatic sewing machine to produce a newly designed line of dresses.

The dresses are priced to sell at $200 each. Management expect to sell 12,000 dresses per year for six years, which is the expected life of this sewing machine. There is, however, some uncertainty about the production costs associated with the new machine.

The Production Department has estimated operating costs at 70% of revenues, but senior management realises that this figure could turn out to be as low as 65% or as high as 75% of revenues.

The new machine is depreciated by straight line method to have a book value of zero at the end of 6 years.

The machine will have an estimated salvage value of $125,000 at the end of six years.

Keener's cost of capital is 14% and its corporate tax rate is 35%.

Using an excel spreadsheet (copies required for each solution), carry out the following calculations:

a) Calculate the NPV for this project using the Production Department's operating costs.

b) Establish the sensitivity of this NPV to variations in operating costs by calculating both the worst case and best case NPV values.

c) The CFO for Keeners is concerned about developments in the future economic conditions. She thinks that there is a 30% chance of adverse economic conditions, 60% chance of normal conditions and 10% chance of a substantial uplift in the economy. For each of these economic scenarios and the variations described below for each, calculate the NPV for each economic condition.

Adverse Conditions

Sales will 8% less than the projected 12,000 dresses for each of the first 3 years, followed by an increase of 2% compounding for the last three years. Operating costs will be 75% of sales. The selling price of each dress will be $190 for the first three years and $200 for the last three years.

Normal Conditions

Sales will be 12,000 dresses for each year, operating costs will be 68% of sales. The selling price of dresses will be $200 each.

Optimistic Conditions

Sales will be 5% higher than the projected 12,000 dresses for the first three years, then an increase of 2% compounding for the last three years. Operating costs will be 70% of sales as suppliers' cost increases are expected with the more buoyant economy. The selling price will be $200 for the first three years, increasing by 3% compounding for the last three years.

d)What is the expected NPV (taking account of the probability of each economic scenario)

e)Briefly discuss your results (assessing the risk) above and provide your recommendation on investing in the new sewing machine and the opportunity to add value to the company from the sales of the new dress line.