Question
Suppose you want to launch a new business. Starting the business would necessitate an initial equipment purchase of $100 million. Additionally, you have previously received
Suppose you want to launch a new business. Starting the business would necessitate an initial equipment purchase of $100 million. Additionally, you have previously received a market analysis study from G&M Marketing that cost $2,500,000. You also have already paid a freelancer $750,000 to design your website and logo. You are projecting this project for the next 7 years, but are using the MACRS 10 year depreciation schedule (fully depreciating the equipment according to the schedule).
Your market analysis along with your own projections/requirements showed the following:
- In your first year you would sell 560,000 units
- The price in the 1st year would be $77
- Your unit COGS would be 40% of the sales price
- Annual overhead would cost $3,750,000
- You would require an initial net working capital (NWC) investment of $5,000,000
- You assume a tax rate of 21%
- You also assume you will be able to sell the equipment for $11,000,000 at the end of the project in 7 years.
- Unit sales (beyond the first year) are expected to grow 4% per year
- You should also be able to increase prices by 2% each year
- Each year you will have to increase NWC by 10% of the expected change in sales (so NWC investment in year 1 is based on the expected change in sales from year 1 to year 2)
- All NWC investment is recovered at the end of the project
- Based on the risk, you need to make a 14% return on this project
As you are looking at your projections and those given to you by G&M Marketing, which estimate is most crucial to the level of success of the company? Is it initial product price or is it fixed costs or is it the unit cost percentage? Demonstrate with a sensitivity analysis (based on the impact of a given percent change in each variable).
This info applies to the problems that follow. The original numbers above are your best guess at what will happen. However, suppose you anticipate the following potential issues with your estimates:
- Your initial number of units sold could be off as much as 15% in either direction
- Your initial price could be up to 10% off in either direction
- Unit COGS will be 40% +/ 5%
- Unit sales growth could be 4% +/- 7.5%
- Annual price increases will be 2% +/- 2.5%
- The salvage value might be off as much as 40% different in either direction
- The needed NWC investment each year will be 5% +/- 1.5% of the change in revenues
What is the best case scenario NPV for your company?
What is the worst case scenario NPV for your company?
Suppose you believe the best case scenario will happen 10% of the time, the worst case scenario will happen 30% of the time and the base case the rest of the time. Should you pursue this project? Explain.
- Suppose, if the best case scenario starts to unfold, that you will allow the project to run through Year 10 (instead of stopping after Year 7) with all of the growth continuing through Year 10. If this happens, youll have the opportunity to sell off the investment for $5m in 10 years.
- What is the best case scenario NPV now?
- Does the option to expand change your answer to whether you should pursue the project (given the probabilities in #7)? Explain/show.
- What is the value of the option to expand? (in dollars) Explain/show.
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