Case Study 2: Moebium Technologies
Situation
Moebium Technologies is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Alan Stukov, a recently graduated MBA. The production line would be set up in unused space in Moebium's main plant. The Zelnagan device’s invoice price would be approximately $400,000, another $50,000 in shipping charges would be required, and it would cost an additional $80,000 to install the equipment. The machinery has an economic life of 4 years, and Moebium has obtained a special tax ruling that places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $75,000 after 4 years of use.
The new line would generate incremental sales of 2,250 units per year for 4 years at an incremental cost of $125 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are expected to increase by 3% per year due to inflation. Further, to handle the new line, the firm’s net working capital would have to increase by an amount equal to 14% of sales revenues. The firm’s tax rate is 40%, and its overall weighted average cost of capital is 12%.
a. Define “incremental cash flow.”
(1.) Should you subtract interest expense or dividends when calculating project cash flow?
(2.) Suppose the firm had spent $200,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain.
(3.) Now assume that the plant space could be leased out to another firm at $40,000 per year. Should this be included in the analysis? If so, how?
(4.) Finally, assume that the new product line is expected to decrease sales of the firm’s other lines by $20,000 per year. Should this be considered in the analysis? If so, how?
Analysis of New Expansion Project
Part I: Input Data
Equipment cost $400,000 Shipping charge $50,000 Installation charge $80,000 Economic Life 4 Salvage Value $75,000 Tax Rate 40% Cost of Capital 12% Units Sold 2,250 Sales Price Per Unit $200 Incremental Cost Per Unit $125 NWC/Sales 14% Inflation rate 3%
b. Disregard the assumptions in Part a. What is Moebium's depreciable basis? What are the annual depreciation expenses? (Hint: Use the MACRS depreciation schedule for a 3-year investment)
c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows?
d. Construct annual incremental operating cash flow statements. (Hint: Are unit price/cost constant?)
Annual Operating Cash Flows
Units Unit price Unit cost
Sales
Costs
Depreciation
Operating income before taxes (EBIT) Taxes (40%)
EBIT (1 – T)
Depreciation
Net operating CF
Year 1
Year 2
Year 3
Year 4
e. Estimate the required net working capital for each year, and the cash flow due to investments in net working capital.
f. Calculate the after-tax salvage cash flow.
g. Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR, MIRR, and payback? Do these indicators suggest the project should be undertaken?
(Remember to show your calculations.)
h. What does the term ”risk” mean in the context of capital budgeting; to what extent can risk be quantified; and when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates?
(1.) What are the three types of risk that are relevant in capital budgeting?
(2.) How is each of these risk types measured, and how do they relate to one another?
(3.) How is each type of risk used in the capital budgeting process?
(1.) What is sensitivity analysis?
(2.) Briefly describe the process Stukov could use to perform a sensitivity analysis, assuming a
percentage deviation from the base case of plus/minus 15% and 30% on the project's WACC, 1st year unit sales, and salvage value.
(3.) What is the primary weakness of sensitivity analysis? What is its primary usefulness?
k. Assume that Alan Stukov is confident of his estimates of all the variables that affect the project’s cash flows except unit sales and sales price: If product acceptance is poor, unit sales would be only 1,200 units a year and the unit price would only be $160; a strong consumer response would produce sales of 2,800 units and a unit price of $240. Stukov believes that there is a 25% chance of poor acceptance, a 25% chance of
excellent acceptance, and a 50% chance of average acceptance (the base case).
k. Assume that Alan Stukov is confident of his estimates of all the variables that affect the project’s cash flows except unit sales and sales price: If product acceptance is poor, unit sales would be only 1,200 units a year and the unit price would only be $160; a strong consumer response would produce sales of 2,800 units and a unit price of $240. Stukov believes that there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case).
(1.) What is scenario analysis?
(2.) Based on the information above, what is the worst-case NPV? The best-case NPV?
(3.) Use the worst-, most likely, and best-case NPVs and probabilities of occurrence to find the project’s expected NPV, standard deviation, and coefficient of variation.
l. Are there problems with scenario analysis? Define Monte Carlo simulation analysis, and discuss its principal advantages and disadvantages.
m. (1.) Assume that Moebium's average project has a coefficient of variation in the range of 0.2 to 0.4. Would the new line be classified as high risk, average risk, or low risk? What type of risk is being measured here?
(2.) Moebium typically adds or subtracts 4 percentage points to the overall cost of capital to adjust for risk. Should the new line be accepted? (Hint: re-calculate NPV if necessary)
(3.) Are there any subjective risk factors that should be considered before the final decision is made?
Subject | Business |
Due By (Pacific Time) | 11/26/2015 02:00 pm |
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