1. Calculate the before-tax 10-year NPV (calculated at the firm's hurdle rate) for a proposed expansion project....
Question:
1. Calculate the before-tax 10-year NPV (calculated at the firm's hurdle rate) for a proposed expansion project.
2. What is your recommendation.
Situation:
You work for a specialty chemical company with annual revenues of $50 million. That firm is seeking to expand. Since the firm is currently selling everything it can produce, it must expand production capacity in order to grow sales. As a result, what is being proposed is a production expansion project. This capital project is estimated to cost $4.75 million, according to the engineering study. The expansion would allow the company to increase sales, albeit not all at once. The market research study suggests that the company's overall revenues could grow by 20% with this expansion, although that growth is estimated to occur over five years. The report assumes a linear growth in sales over those five years. After that point, the firm's sales would again match the firm's production capacity, so no further sales growth would occur.
The firm's CFO has asked you to run some numbers on the expansion. Specifically, she has asked you to calculate the project's pre-tax 10-year NPV of the free cash flow associated with this project. You know from doing financial projects for the firm before, that the firm prefers to calculate the NPV at a project "hurdle rate" which is 1% higher than the company's WACC of 6.7%. You also know that the construction costs will be recorded in "Year 0" and the incremental sales, due to the expansion, will begin in Year 1. The standard practice in this company is to include annual facility maintenance costs to expansion project financial analysis. The standard company rate is to charge 5% of the project's total PP&E cost annually. The CFO has specifically asked you to ignore any increases to the firm's working capital that may occur as a result of the expansion. You further know that the firm typically uses a 20-year straight-line depreciation for capital investments, but since you have been asked to calculate the project's cash flow you do not need to worry about depreciation.
The CFO wants you to run two scenarios. The "base case" where everything goes according to the forecasts of the engineering and marketing groups. The CFO feels pretty good about the capital estimates for the project coming from the engineering group. She is less confident in the sales growth numbers from the marketing department. Marketing is anticipating revenue to grow 20% (over five years) as a result of this project, but the CFO is asking you to determine the overall sales growth that would generate an NPV of zero. That would be the lowest acceptable sales growth for the project to be financially viable. Any growth less than that value and the company would lose money on this expansion.2 Here's what you also know about the firm's products, which will not change with the expansion. (The company has no on-going R&D costs.) COGS: 79.1% SG&A: 4.3%
Your report back to the CFO will include the following.
(1) The Excel model you have built
(2) Summarizes the situation and the results with a. Assumptions b. Base case NPV c. Sales growth rate that creates an NPV of zero d. Your "go" "no go" recommendation to the CFO based on your analysis and your justification for that recommendation