HMG Corporation is considering the manufacture of a new chemical compound that is used to make high-pressure plastic containers. An investment of $ 4 million in plant and equipment is required. The firm estimates that the investment will have a five-year life, and will use straight-line depreciation toward a zero salvage value. However, the investment has an anticipated salvage value equal to 10% of its original cost. The number of pounds (in millions) of the chemical compound that HMG expects to sell over the five-year life of the project is as follows: 1.0, 1.5, 3.0, 3.5, and 2.0. To operate the new plant, HMG estimates that it will incur additional fixed cash operating expenses of $ 1 million per year and variable operating expenses equal to 45% of revenues. HMG also estimates that in year t it will need to invest 10% of the anticipated increase in revenues for year t + 1 in net working capital. The price per pound for the new compound is expected to be $ 2.00 in years 1 and 2, then $ 2.50 per pound in years 3 through 5. HMG’s tax rate is 38%, and it requires a 15% rate of return on its new-product investments.
a. Cash flows for the entire life of the proposed investment. Note that investment cash flow is derived from the additional revenues and costs associated with the proposed investment. Verify the calculation of project cash flow for year 5.
b. Does this project create shareholder value? How much? Should HMG undertake the investment? Explain your answer.
c. What if the estimate of the variable costs were to rise to 55%? Would this affect your decision?