Illinois Fabrics Inc. makes upholstery that’s used in high-quality furnture, largely chairs and sofas. Illinois has traditionally sold their fabric to manufacturers who the finished product to furniture stores. Management has analyzed the finished chairs and sofas of several manufacturers and found that the highest value element they contain is the Illinois fabric. They further found that generally the frames were shoddily produced.
Illinois’ VP of Manufacturing, Harrison Flatley, has proposed starting a new business called Illinois Furniture which will produce and market the end product using the fabric the firm already manufactures. Harrison has put together a proposal to start such a venture which results in a steady stream of cash income of $5 million per year after an initial investment of $25 million to be spent on manufacturing facilities and the development of a sales relationship with retailers. The analysis comes up with an NPV for the project assuming the income stream is a perpetuity and taking its present value at Illinois’ 10% cost of capital.
NPV= -$25M + $5M/.10= -$25M + $50M =$25M
Top management likes the idea but is concerned about risk in two areas. First, furniture manufacturing seems to be a riskier business than making fabric as manufacturing firms are always entering and leaving the industry. The average beta of the publicly traded end product manufacturers is a relatively high 1.9. By contrast, Illinois’ beta is .9. Second, management fears that an economic downturn would impact a new business more seriously than it would the existing competitors. Management fears that there’s a 40% chance of a downturn in the near future which would reduce Harrison’s income projections by 20%. Re-analyze Harrison’s proposal and make a recommendation to management. Treasury bills are yielding 4% and the S&P 500 index is yielding 10%.