Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

Webmasters.com has developed a powerful new server that would be used for corporations Internet activities. It would cost $10 million at Year 0 to buy

Webmasters.com has developed a powerful new server that would be used for corporations Internet activities. It would cost $10 million at Year 0 to buy the equipment necessary to manufacture the server. The project would require net working capital at the beginning of each year in an amount equal to 10% of the year's projected sales; for example, NWC0 = 10%(Sales1). The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 3%.

The companys nonvariable costs would be $1 million at Year 1 and would increase with inflation.

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 project's returns are expected to be highly correlated with returns on the firm's other assets. The firm believes it could sell 1,000 units per year.

The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of the equipment at the end of the projects 4-year life is $500,000. Webmasters federal-plus-state tax rate is 40%. Its cost of capital is 10% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 and 1.2. Low-risk projects are evaluated with a WACC of 8%, and high-risk projects at 13%.

A Develop a spreadsheet model, and use it to find the projects NPV, IRR, and payback.

Input Data (in thousands of dollars)

Equipment cost

$10,000

Key Results:

Net operating working capital/Sales

10%

NPV =

First year sales (in units)

1,000

IRR =

Sales price per unit

$24.00

Payback =

Variable cost per unit (excl. depr.)

$17.50

Nonvariable costs (excl. depr.)

$1,000

Market value of equipment at Year 4

$500

Tax rate

40%

WACC

10%

Inflation in prices and costs

3.0%

Estimated salvage value at year 4

$500

Intermediate Calculations

0

1

2

3

4

Units sold

Sales price per unit (excl. depr.)

Variable costs per unit (excl. depr.)

Nonvariable costs (excl. depr.)

Sales revenue

Required level of net operating working capital

Basis for depreciation

$10,000

Annual equipment depr. rate

20.00%

32.00%

19.20%

11.52%

Annual depreciation expense

Ending Bk Val: Cost Accum Dep'rn

$10,000

Salvage value

$500

Profit (or loss) on salvage

Tax on profit (or loss)

Net cash flow due to salvage

Years

Cash Flow Forecast

0

1

2

3

4

Sales revenue

Variable costs

Nonvariable operating costs

Depreciation (equipment)

Oper. income before taxes (EBIT)

Taxes on operating income (40%)

Net operating profit after taxes

Add back depreciation

Equipment purchases

Cash flow due to change in NOWC

Net cash flow due to salvage

Net Cash Flow (Time line of cash flows)

b. Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and number of units sold. Set these variables values at 10% and 20% above and below their base-case values.

c. Now conduct a scenario analysis. Assume that there is a 25% probability that best-case conditions, with each of the variables discussed in Part b being 20% better than its base-case value, will occur. There is a 25% probability of worst-case conditions, with the variables 20% worse than base, and a 50% probability of base-case conditions.

d. If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and payback.

e. On the basis of information in the problem, would you recommend that the project be accepted? Use the space below to formulate your answer and reasoning:

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Foundations Of Financial Markets And Institutions

Authors: Franco Modigliani, Frank J. Jones, Michael G. Ferri, Frank J. Fabozzi

3rd Edition

0130180793, 978-0130180797

More Books

Students also viewed these Finance questions