Evaluating Cherone Equipment's Plans With Varying Risk for Increasing Its Production Capacity   Cherone Equipment, a manufacturer of electronic fitness equipment, wishes to evaluate two alternative plans for increasing its production capacity to meet the rapidly growing demand for its key product-the Cardiocycle. After months of investigation and analysis, the firm has pruned the list of alternatives down to the following two plans, either of which would allow it to meet its forecast product demand.

 

Plan X Use current proven technology to expand the existing plant and semiautomated production line. This plan is viewed as only slightly more risky than the firm's current average level of risk.

 

Plan Y Install new, just-developed automatic production equipment in the existing plant to replace the current semiautomated production line. Because this plan eliminates the need to expand the plant, it is less expensive than Plan X, but it is believed to be far more risky because of the unproven nature of the technology.

 

Cherone, which routinely uses NPV to evaluate capital budgeting projects, has a cost of capital of

12%.

Currently the risk-free rate of interest,

RF,

is

9%.

The firm has decided to evaluate the two plans over a

5-year

time period, at the end of which each production line would be liquidated. The relevant cash flows associated with each plan are summarized in the following table.

 

	Plan X	Plan Y
Initial investment (CF0)	$2,700,000	$2,100,000
Year (t )	Cash inflows (CFt)
1	$470,000	$380,000
2	610,000	700,000
3	950,000	800,000
4	970,000	600,000
5	1,500,000	1,200,000

 

The firm has determined the risk-adjusted discount rate (RADR) applicable to each plan as shown in the following table.

 

	Risk-adjusted
Plan	discount rate (RADR)
X	13%
Y	15%

 

Further analysis of the two plans has disclosed that each has a real option embedded within its cash flows.

 

Plan X Real

Option—At

the end of

3

years the firm could abandon this plan and install the automatic equipment, which by then would have a proven track record. This abandonment option is expected to add

$100,000

of NPV and has a

25%

chance of being exercised.

 

Plan Y Real

Option—Because

plan Y does not require current expansion of the plant, it creates an improved opportunity for future plant expansion. This option allows the firm to grow its business into related areas more easily if business and economic conditions continue to improve. This growth option is estimated to be worth

$500,000

of NPV and has a

20%

chance of being exercised.

 

To Do

 

a. Assuming that the two plans have the same risk as the firm, use the following capital budgeting techniques and the firm's cost of capital to evaluate their acceptability and relative ranking.

 

(1) Net present value (NPV).

 

(2) Internal rate of return (IRR).

 

b. Recognizing the differences in plan risk, use the NPV method, the risk-adjusted discount rates (RADRs), and the data given earlier to evaluate the acceptability and relative ranking of the two plans.

 

c. Compare and contrast your finding in parts

(a)

and

(b).

Which plan would you recommend? Did explicit recognition of the risk differences of the plans affect this recommendation?

 

d. Use the real-options data given above for each plan to find the strategic NPV, NPVstrategic, for each plan.

 

e. Compare and contrast your findings in part d with those in part

(b).

Did explicit recognition of the real options in each plan affect your recommendation?

 

f. Would your recommendations in parts

(a),

(b),

and

(d)

change if the firm were operating under capital rationing? Explain.