Question
Standard Food Company plans to establish a new production line for producing ice creams. The equipment costs $500,000 with a 10-year life. For depreciation the
Standard Food Company plans to establish a new production line for producing ice creams. The equipment costs $500,000 with a 10-year life. For depreciation the company is using MACRS method. The project is projected to generate $ 200,000 worth of sale in the first year. The sale will grow at 10% per year until the end of year 5, and then -10% per year until the end of year 10. The annual fixed expense is $ 40,000 per year, and the variable cost is always 35% of the revenue of the same year. Starting at year 0, the company needs to maintain an inventory that is worth 15% of next years sale. At the end of the project, no inventory needs to be maintained and all existing inventory will be liquidated. Also, at the end of the project the equipment will be sold at a market value of $ 30,000. Assuming the tax rate is 40% and the cost of capital is 9% for the company.
The company faces two different scenarios: one is the scenario in part a and b with 1st year sales as 200,000; in another scenario, 1st year sales is 175,000. The probability of each scenario is listed below:
Bad:40% Probability - Sales at Year 1: 175,000
Good:60% Probability - Sales at Year 1: 200,000
a.) Solve the NPV for each scenario, and the expected NPV and standard deviation of NPV based on all scenarios.
b.) Calculate the sensitivity of NPV to revenue and the sensitivity of NPV to cost of equipment. Report which variable would affect NPV to a greater degree.
c.)One year before the project starts, the company has an option to test the market. After the testing, the company would know whether the projects sales will be good or bad. If the sale is going to be bad, the company would not start the project. Without the test, the company would start the project nonetheless and bear the risk of bad sales. Calculate the value of the test option, given the test costs $10,000.
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