TASTY FOODS CORPORATION (B)

Capital Budgeting and Risk Analysis

In Case Tasty Foods Corporation (A), you analyzed a lite athletic drink project for Abigail Abercrombie, the daughter of Tasty Foods Corporations founder. The project is expected to require an initial investment of $805,000 in fixed assets (including shipping and installation charges), plus a $30,000 addition to net working capital. The machinery would be used for 4 years and be depreciated on the basis of a 3-year MACRS class life. The appropriate MACRS depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively, and the machinery is expected to have a salvage value of $87,500 after 4 years of use. If the project is undertaken, the firm expects to sell 700,000 cartons annually of High Energy-Lite for the life of the project at a current dollar (Year 0) wholesale price of $2 per carton. However, the sales price will be adjusted for inflation, which is expected to average 4 percent annually, so the actual expected sales price at the end of the first year is $2.08, and so on.

Because the two product lines are somewhat competitive, the lite athletic drink project is expected to cannibalize the before-tax profit Tasty Foods earns on its regular athletic drink sales by $45,000. Fixed costs (other than deprecation) associated with production of the lite product are expected to amount to $190,000 per year. Year 0 variable cash operating costs per unit are estimated at $1.25 and expected to increase by 2 percent per year. Tasty Foods tax rate is 40 percent, and its cost of capital for an average project is 12 percent.

When Abigail presented your initial analysis to Tasty Foods Executive Committee, things went well, and she was congratulated on both the analysis and the presentation. She, in turn, congratulated you on a job well done. However, several questions were raised during the meeting, and Abigail has asked for your assistance once more. In particular, the Executive Committee wanted to see more risk analysis on the lite project - it appeared to be profitable, but what were the chances that it might nevertheless turn out to be a loser, and how should risk be analyzed and worked into the decision process? As the meeting was winding down, Abigail was asked to start with the based case situation you had developed and then to discuss risk analysis, both in general terms and as it should be applied to the lite athletic drink project.

You met with the marketing and production managers to get a feel for the uncertainties involved in the cash flow estimates. After several sessions, you concluded that the greatest uncertainty involved unit sales and salvage value. Cost estimates were fairly well defined, but unit sales could vary widely, and the realized salvage value could be quite different from the $87,500 estimate. Companies in competitive market typically set sales prices on the basis of competitors price, so, at least initially, you decided to treat the sales prices as being fairly certain. However, the supply of ingredients for the lite drink can rise or fall sharply due to market production and demand conditions, and that can lead to large price swings in both variable costs and product sales prices.

As estimated by the marketing staff, if product acceptance is normal, then sales quantity during the life of the project would be 700,000 units annually; if acceptance is poor, then only 450,000 units would be sold annually during the life of the project (the price would be kept at the forecasted level), and if consumer response is strong, then the sales volume would be 950,000 units annually during the life of the project. In addition, the production manager believes that the equipments Year 4 salvage value could be as low as zero and as high as $125,000, depending on the demand for such equipment after 4 years. In all cases, sales price and variable cash operating cost per unit are still expected to increase at the inflation rates of 4 percent and 2 percent, respectively.

Abigail also discussed the scenarios probabilities with the marketing staff. After considerable debate, they finally agreed on a guesstimate of 25 percent probability of poor acceptance, 50 percent probability of average acceptance, and 25 percent probability of excellent acceptance. In addition, Tasty Foods Executive Committee requires that all sensitivity analyses consider changes in at least the following variables: sales quantity, sales price, variable cost, salvage value, and the cost of capital. Company policy also mandates that each of the variables be allowed to deviate from its expected value by plus or minus 10 percent, 20 percent, and 30 percent in such an analysis.

Abigail also discussed with Claude Vandermere, Tasty Foods director of capital budgeting, both the risk inherent in the firms average project and how it typically adjusts for risk. Based on historical data, most of Tasty Foods projects have had coefficient of variation (CV) of NPV in the range of 0.50 to 1.00, and Vandermere has been adding or subtracting 3 percentage points to the cost of capital for projects whose CVs lie outside that range to adjust for differential project risk. Abigail and you wonder about whether the cash flows from the lite athletic drink project would be positively or negatively correlated with the sales of Tasty Foods other drinks and the S&P 500, and you also wondered how these correlations should be dealt with in the analysis.

The discussion with Vandermere raised another issue: Should the projects cost of capital be based on its stand-alone risk, on its risk as measured within the context of the firms portfolio of assets (within-firm, or corporate, risk), or in a market risk context? Tasty Foods target capital structure calls for 40 percent debt and 60 percent common equity, and the before-tax marginal cost of debt is currently 13%. You also determined that the Treasury bond rate, which you use as the long-term risk-free rate, is 8.2 percent, and that the market risk premium is 7 percent. In addition, you estimated that the market beta for the project would be about 1.75.

Since most members of Tasty Foods Executive Committee are unfamiliar with modern techniques of risk analysis, Abigail decided to first discuss the types of risk that are normally considered in capital budgeting, and then to consider the strengths and weakness of risk analysis. Next, she plans to discuss a comprehensive risk analysis including sensitivity analysis, scenario analysis and an estimate of the projects different risk-adjusted profitability. Finally, she plans to carry out or at least discuss Monte-Carlo simulation, and then to provide a comparison of the various risk-analysis techniques

QUESTIONS

1. Assume that sales price will increase by the 4 percent inflation rate beginning after Year 0 (i.e. sales price is $2.00 per unit at Year 0 and $2.08 at Year 1 - the end of first year). However, cash operating costs will increase by only 2 percent annually from Year 0. For simplicity, assume that no other cash flows are affect by inflation. Estimate the projects cash flows each year during the next four years by including cannibalization effect but excluding consideration of the cash flows associated with use of the building. What are the projects NPV, ITT, MIRR and payback? (Hint: use Excel Template as guide)

2. a. Why should firms be concerned with the riskiness of individual projects?
   2. (1) What are the three types of risk that are normally considered in capital budgeting?

(2) Which type of risk is most relevant? Why?

(3) Which type of risk is easiest to measure?

3. a. What is sensitivity analysis?
   2. Complete the sensitivity analysis table in the Excel Template, assuming initially that the project has average risk. Assume that each of these variables can deviate from its base case, or expected value, by plus or minus 10 percent, 20 percent, and 30 percent.
   3. Prepare a sensitivity diagram (this part is optional and you dont have to do it) and discuss the results.
   4. What are the primary weakness of sensitivity analysis? What are its primary advantages?

4. Complete the scenario analysis in Excel Template. Use the worst-case, base-case (most likely), and best-case NPVs, and their probabilities of occurrence, to find the projects expected NPV, standard deviation, and coefficient of variation. Is this project an average-risk project, or a low-risk project, or a high-risk project?

6. Based on the risk level of the project to determine the appropriate cost of capital (the discount rate to be used to estimate NPV), then calculate the projects risk-adjusted NPV. Should the project be accepted? What if it had a coefficient of variation (CV) of NPV of only 0.15 and was judged to be a low-risk project?