$[$Your company$]$ has developed a new procedure that greatly improves durability and efficiency. After spending $$500,000$ on the research and development, $[$company$]$ is considering implementing the procedure in a project that requires an initial investment of $$9,000,000$ in new equipment.

The equipment must be purchased before the new procedure can begin. For tax purposes, the equipment is subject to a $5-$year straight$-$line depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that the asset can actually be used out into the indefinite future $($i$.$e$.,$ the actual useful life is effectively infinite$).$

$[$Company$]$ anticipates that the sales will be $$30,000,000$ in the first year $($Year $1).$ They expect that sales will initially grow at an annual rate of $6\%$ until the end of fifth year. After that, the sales will grow at the estimated $2\%$ annual rate of inflation in perpetuity.

The cost of goods sold is estimated to be $72\%$ of sales.

The accounting department also estimates that at introduction in Year $0,$ the new project$$s required initial net working capital will be $$6,000,000.$ In future years accounts receivable are expected to be $15\%$ of the next year sales, inventory is expected to be $20\%$ of the next year$$s cost of goods sold and accounts payable are expected to be $15\%$ of the next year$$s cost of goods sold.

The selling, general and administrative expense is estimated to be $$6,000,000$ per year, but $$1$ million of this amount is the overhead expense that will be incurred even if the project is not accepted.

The research and development to support the product was completed last month at a cost of $$500,000$ to be paid by the end of next year.

The annual interest expense tied to the project is $$1,000,000.$

$[$Company$]$ has a cost of capital of $20\%$ and faces a marginal tax rate of $21\%$ and an average tax rate is $30\%.$

Instructions

I posted an incomplete Excel template for your analysis. You need to figure out how to construct the pro forma income statements and calculate the incremental unlevered net income. You should include ONLY the factors that will affect your capital budgeting decision. Revise the template if necessary.

Note that your analysis should be set up so the assumptions that impact the cash flow estimates can be easily changed to identify the sensitivity of your calculations to these assumptions.

There are three sheets in the template. Use the worksheet $$NPV$$ for questions $1$ to $4,$ and the other two sheets for questions $5$ and $6.$

Submit your Excel spreadsheet through blackboard. Clearly show your work so that I can trace your numbers.

Questions

Use Excel to construct six$-$year pro forma income statements and calculate the incremental unlevered net income for the first six years.

Calculate six$-$year projections for free cash flows. Remember to include cash flows from the income statement and depreciation, changes in net working capital, and capital expenditures or dispositions.

Hint: You need to calculate the level of net working capital $($NWC$)$ and change in NWC$.$Pay attention to the timing of NWC$.$

$[$Company$]$ expects that free cash flow from Year $6$ onwards will increase at a constant rate of $2\%/$year into the indefinite future. Calculate PV$($terminal value that captures the value of future free cash flows in Year $6$ and beyond$).$ That is$,$ calculate the terminal value first, then find its value in Year $0($today$).$ If you need to calculate free cash flow for Year $7$ or later, use the free cash flow growth rate and the previous free cash flow. Do not construct the entire unlevered net income in order to calculate the free cash flow.

Hint: We went over this in Lecture Note $6,$ so let me briefly review the key points:

Assuming the cash flows grow at a constant rate g after Year N$+1,$ then

Year N TV $=($Year N$+1$ CF$)/($r$$g$)($from growing perpetuity formula$).$

where r is discount rate

We should discount this Terminal Value back to Year $0.$

Determine the NPV of the project. Remember to net out any initial cash outflows.

Perform a sensitivity analysis on four parameters: Select four parameters from the list below and explain why those parameters are important to analyze for your company. Make sure your explanation makes sense for YOUR company. For example a retail company may be very concerned with inventory. The Worst and Best case for each assumption is already provided. Write your answer in Excel.

Parameter

Initial Assumption

Worst Case

Best Case

Sales in Year $1($in thousands$)$

$$30,000$

$$27,000$

$$33,000$

Sales Growth through Year $5$

$6\%$

$0\%$

$10\%$

Cost of Goods Sold $(\%$ of Sales$)$

$72\%$

$77\%$

$67\%$

Accounts Receivable $\%$ of Next Year Sales

$15\%$

$20\%$

$10\%$

Inventory $\%$ of Next Year