You must analyze a potential new product—a caulking compoundthat Cory Materials’ R&D people developed for use in the residential constructionindustry. Cory’s marketing manager thinks the company can sell 115,000 tubes peryear at a price of $3.25 each for 3 years, after which the product will be obsolete. Therequired equipment would cost $150,000, plus another $25,000 for shipping and installation.Current assets (receivables and inventories) would increase by $35,000, while currentliabilities (accounts payable and accruals) would rise by $15,000. Variable cost perunit is $1.95, fixed costs (excluding depreciation) would be $70,000 per year, and fixedassets would be depreciated under MACRS with a 3-year life. (Refer to Appendix 12Afor MACRS depreciation rates.) When production ceases after 3 years, the equipmentshould have a market value of $15,000. Cory’s tax rate is 40%, and it uses a 10% WACCfor average-risk projects.a. Find the required Year 0 investment and the project’s annual cash flows. Then calculatethe project’s NPV, IRR, MIRR, and payback. Assume at this point that the projectis of average risk.b. Suppose you now learn that R&D costs for the new product were $30,000 and thatthose costs were incurred and expensed for tax purposes last year. How would thisaffect your estimate of NPV and the other profitability measures?c. If the new project would reduce cash flows from Cory’s other projects and if the newproject would be housed in an empty building that Cory owns and could sell, howwould those factors affect the project’s NPV?d. Are this project’s cash flows likely to be positively or negatively correlated withreturns on Cory’s other projects and with the economy, and should this matter in youranalysis? Explain.e. Unrelated to the new product, Cory is analyzing two mutually exclusive machines thatwill upgrade its manufacturing plant. These machines are considered average-riskprojects, so management will evaluate them at the firm’s 10% WACC. Machine Xhas a life of 4 years, while Machine Y has a life of 2 years. The cost of each machineis $60,000; however, Machine X provides after-tax cash flows of $25,000 per year for4 years and Machine Y provides after-tax cash flows of $42,000 per year for 2 years. Themanufacturing plant is very successful, so the machines will be repurchased at the endof each machine’s useful life. In other words, the machines are “repeatable” projects.1. Using the replacement chain method, what is the NPV of the better machine?2. Using the EAA method, what is the EAA of the better machine?f. Spreadsheet assignment: at instructor’s option Construct a spreadsheet that calculatesthe cash flows, NPV, IRR, payback, and MIRR.g. The CEO expressed concern that some of the base-case inputs for the caulking compoundmight be too optimistic or too pessimistic, and he wants to know how the NPVwould be affected if these six variables were 20% above or 20% below the base-caselevels: unit sales, sales price, variable cost, fixed costs, WACC, and equipment cost.Hold other things constant when you consider each variable and construct a sensitivitygraph to illustrate your results.h. Do a scenario analysis based on the assumption that there is a 25% probability thateach of the six variables itemized in part g will turn out to have their best-case valuesas calculated in part g, a 50% probability that all will have their base-case values, anda 25% probability that all will have their worst-case values. The other variables remainat base-case levels. Calculate the expected NPV, the standard deviation of NPV, andthe coefficient of variation.i. Does Cory’s management use the risk-adjusted discount rate to adjust for project risk?Explain.
You must analyze a potential new product—a caulking compound
that Cory Materials’ R&D people developed for use in the residential construction
industry. Cory’s marketing manager thinks the company can sell 115,000 tubes per
year at a price of $3.25 each for 3 years, after which the product will be obsolete. The
required equipment would cost $150,000, plus another $25,000 for shipping and installation.
Current assets (receivables and inventories) would increase by $35,000, while current
liabilities (accounts payable and accruals) would rise by $15,000. Variable cost per
unit is $1.95, fixed costs (excluding
assets would be depreciated under MACRS with a 3-year life. (Refer to Appendix 12A
for MACRS depreciation rates.) When production ceases after 3 years, the equipment
should have a market value of $15,000. Cory’s tax rate is 40%, and it uses a 10% WACC
for average-risk projects.
a. Find the required Year 0 investment and the project’s annual cash flows. Then calculate
the project’s
is of average risk.
b. Suppose you now learn that R&D costs for the new product were $30,000 and that
those costs were incurred and expensed for tax purposes last year. How would this
affect your estimate of NPV and the other profitability measures?
c. If the new project would reduce cash flows from Cory’s other projects and if the new
project would be housed in an empty building that Cory owns and could sell, how
would those factors affect the project’s NPV?
d. Are this project’s cash flows likely to be positively or negatively correlated with
returns on Cory’s other projects and with the economy, and should this matter in your
analysis? Explain.
e. Unrelated to the new product, Cory is analyzing two mutually exclusive machines that
will upgrade its manufacturing plant. These machines are considered average-risk
projects, so management will evaluate them at the firm’s 10% WACC. Machine X
has a life of 4 years, while Machine Y has a life of 2 years. The cost of each machine
is $60,000; however, Machine X provides after-tax cash flows of $25,000 per year for
4 years and Machine Y provides after-tax cash flows of $42,000 per year for 2 years. The
manufacturing plant is very successful, so the machines will be repurchased at the end
of each machine’s useful life. In other words, the machines are “repeatable” projects.
1. Using the replacement chain method, what is the NPV of the better machine?
2. Using the EAA method, what is the EAA of the better machine?
f. Spreadsheet assignment: at instructor’s option Construct a spreadsheet that calculates
the cash flows, NPV, IRR, payback, and MIRR.
g. The CEO expressed concern that some of the base-case inputs for the caulking compound
might be too optimistic or too pessimistic, and he wants to know how the NPV
would be affected if these six variables were 20% above or 20% below the base-case
levels: unit sales, sales price, variable cost, fixed costs, WACC, and equipment cost.
Hold other things constant when you consider each variable and construct a sensitivity
graph to illustrate your results.
h. Do a scenario analysis based on the assumption that there is a 25% probability that
each of the six variables itemized in part g will turn out to have their best-case values
as calculated in part g, a 50% probability that all will have their base-case values, and
a 25% probability that all will have their worst-case values. The other variables remain
at base-case levels. Calculate the expected NPV, the standard deviation of NPV, and
the coefficient of variation.
i. Does Cory’s management use the risk-adjusted discount rate to adjust for project risk?
Explain.
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d. Are this project’s cash flows likely to be positively or negatively correlated with
returns on Cory’s other projects and with the economy, and should this matter in your
analysis? Explain.
e. Unrelated to the new product, Cory is analyzing two mutually exclusive machines that
will upgrade its manufacturing plant. These machines are considered average-risk
projects, so management will evaluate them at the firm’s 10% WACC. Machine X
has a life of 4 years, while Machine Y has a life of 2 years. The cost of each machine
is $60,000; however, Machine X provides after-tax cash flows of $25,000 per year for
4 years and Machine Y provides after-tax cash flows of $42,000 per year for 2 years. The
manufacturing plant is very successful, so the machines will be repurchased at the end
of each machine’s useful life. In other words, the machines are “repeatable” projects.
1. Using the replacement chain method, what is the
2. Using the EAA method, what is the EAA of the better machine?
f. Spreadsheet assignment: at instructor’s option Construct a spreadsheet that calculates
the cash flows, NPV,
g. The CEO expressed concern that some of the base-case inputs for the caulking compound
might be too optimistic or too pessimistic, and he wants to know how the NPV
would be affected if these six variables were 20% above or 20% below the base-case
levels: unit sales, sales price, variable cost, fixed costs, WACC, and equipment cost.
Hold other things constant when you consider each variable and construct a sensitivity
graph to illustrate your results.
h. Do a scenario analysis based on the assumption that there is a 25% probability that
each of the six variables itemized in part g will turn out to have their best-case values
as calculated in part g, a 50% probability that all will have their base-case values, and
a 25% probability that all will have their worst-case values. The other variables remain
at base-case levels. Calculate the expected NPV, the standard deviation of NPV, and
the coefficient of variation.
i. Does Cory’s management use the risk-adjusted discount rate to adjust for project risk?
Explain.
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