Question
Webmasters Inc., a San Francisco based technology company, has developed a powerful new server that would be used for corporations' Internet activi ties. This effort
Webmasters Inc., a San Francisco based technology company, has developed a powerful new server that would be used for corporations' Internet activi ties. This effort has now reached the stage where a decision on whether or not to go forw ard with production must be made. As one of the companys financial analysts, you have b een assigned the task of supervising the capital budgeting analysis. The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years . Also, the projects returns a re expected to be highly correlated with returns on t he firms other assets. The firm would pay $80,000 to a consulting firm to conduct mark et analysis. It would cost $10 million to buy the equipment necessary to man ufacture the server. The project would also require net operating working capital equal to 10% of next years projected sales. The firm expects to sell 1,000 units of new server per year, st arting 2014. Each unit of server could be sold for $24,000 per unit. The operation depar tment expects that the variable costs would amount to $17,500 per unit. After the firs t year the unit sale price and unit variable costs will incr ease at the inflation rate of 3%. The company's fixed costs would be $1 million per year and wou ld also increase with infla tion. The equipment would be depreciated over a 5-year period, follow ing MACRS 5-year schedule. The estimated market va lue of the equipment at the en d of the project's 4 year life is $500,000. Webmasters' federa l-plus-state tax rate is 40 %. Estimate the project cash flows fo r each year and set up the sp readsheet model for the project. Calculate the projects NPV, IRR, MIRR, PI, PB and discounted P B, assuming that the cost of cap ital (WACC) is 10%. Conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable cost per unit, and number of units so ld. Set these variable' values at 10% and 20% above and bel ow their base-case values. back Reiman School of Finance Corporate Financial P roblems 2 Conduct a scenario analysis. Assume that there is a 25% probabi lity that "best- case" conditions, with sales price, variable cost per unit, and number of units sold being 20% better than its base-ca se value, will occur. There is a 25% probability of "worst-case" conditions, with the sales price, variable cost per unit, and number of units sold being 20% worse th an base, and a 50% probability of base-case conditions. Calculate the project s expected NPV, standard devi ation, and coefficient of variation. Assume that the average projects of Webmasters have a coefficie nt of variation in the range of 0.8 1.2, and the cost of capital is 10% for aver age-risk projects. Does the project appear to be more or less risky than an averag e project? Should the cost of capital be adjusted to evaluate this project? Webma sters typically uses the adjustment factor of 2% for the low-risk projects and 3% fo r the high-risk projects. Calculate the risk-adjusted NPV. Based on your analysis, should the firm take this project? Explain why.
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