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 they can sell 115,000 tube per year at a price of $3.25 per year 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 would increase by $35,000 while current liabilities would rise by $15,000. Variable costs would be 60% of sales revenues, fixed costs (excluding depreciation) would be $70,000 per year, and fixed assets would be depreciated under MACRS with a 3-year life. The relative depreciation rates would be 33.33%, 44.44%, 14.82% and 7.41%. When production ceases after 3 years, the equipment will have a market value of $15,000. Cory’s tax rate is 40% and it uses a 10% wacc for average-risk projects.
a. Calculate the project’s NPV, IRR, MIRR, PI, payback and discounted payback.
b. Suppose you 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 ash 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 he projects’ NPV?
d. Are this project’s 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. 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% better or 20% worse than the base-case levels: unit sales, sales price, variable costs, fixed costs, wacc, and equipment cost. Hold other things constant when you consider each variable and construct a sensitivity graph to illustrate your results.
f. Do a scenario analysis on the assumption that there is a 25% probability that each of the six variables itemized in part (e) will turn out to have their best-case values as calculated in Part (e), a 50% chance probability that all will have their base-case values, and a 25% probabililty that 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.
g. Based on the risk analysis, make a recommendation to Cory Materials regarding the caulking compound.
h. 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. Using the replacement chain method, what is the NPV of the better machine? Using the Equivalent Annual Annuity method, what is the EAA of each machine?
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