The Cranberry company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated MBA. The production line would be set up in unused space in Cranberrys main plant. The machinerys invoice price would be approximately $200,000, another $10,000 in shipping charges would be required, and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 4 years, and Cranberry has obtained a special tax ruling that places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $20,000 after 4 years of use.

The new line would generate incremental sales of 1,050 units per year for the first year at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are expected to increase by 3% per year due to inflation. Further, to handle the new line, the firms net working capital would have to increase by an amount equal to 12% of sales revenues. The firms tax rate is 26%, and its overall weighted average cost of capital is 10%.

9. Risk Analysis

   1. What are the three types of risk that are relevant in capital budgeting?

   2. How is each of these risk types measured, and how do they relate to one another?

   3. How is each type of risk used in the capital budgeting process?

10. Sensitivity Analysis

    1. What is sensitivity analysis?

    2. Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the project. Assume each of these variables can vary from its base-case, or expected, value by 10%, 20%, and 30%. Include a sensitivity diagram, and discuss the results.

    3. What is the primary weakness of sensitivity analysis? What is its primary usefulness?

11. Assume that Sidney Johnson is confident of her estimates of all the variables that affect the projects cash flows except unit sales and sales price. If product acceptance is poor, unit sales would be only 900 units a year and the unit price would only be $160; a strong consumer response would produce sales of 1,300 units and a unit price of $240. Sidney believes that there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case).

    1. What is scenario analysis?

    2. What is the worst-case NPV? The best-case NPV?

    3. Use the worst-, base-, and best-case NPVs and probabilities of occurrence to find the projects expected NPV, standard deviation, and coefficient of variation.

12. Are there problems with scenario analysis? Define simulation analysis, and discuss its principal advantages and disadvantages.

    1. Perform a Simulation Analysis (please discuss with your professor the assumption that you will make before performing the simulation).

13. Wrapping up

    1. Assume that Cranberrys average project has a coefficient of variation in the range of 0.2 to 0.4. Would the new line be classified as high risk, average risk, or low risk? What type of risk is being measured here?

    2. Cranberry typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk. Should the new line be accepted?

    3. Are there any subjective risk factors that should be considered before the final decision is made?