As a financial analyst, you must evaluate a proposed project to produce printer cartridges. The equipment would cost $55,000, plus $10,000 for installation. Annual sales would be 4,000 units at a price of $50 per cartridge, and the projects life would be 3 years. Current assets would increase by $5,000 and payables by $3,000. At the end of 3 years, the equipment could be sold for $10,000. Depreciation would be based on the MACRS 3-year class. Variable costs would be 70% of sales revenues; fixed costs excluding depreciation would be $30,000 per year; the marginal tax rate is 40%; and the corporate WACC is 11%.

a. What is the required investment, that is, the Year 0 project cash flow?

b. What are the annual depreciation charges?

c. What are the projects annual cash flows?

d. If the project is of average risk, what is its NPV? Should it be accepted?

e. Management is uncertain about the exact unit sales. What would the projects NPV be if

unit sales turned out to be 20% below forecast, but other inputs were as forecasted?

Would this change the decision? Explain.

f. The CFO asks you to do a scenario analysis using these inputs:

Other variables are unchanged. What are the expected NPV, its standard deviation, and

the coefficient of variation?

g. The firms project CVs generally range from 1.0 to 1.5. A 3% risk premium is added to the

WACC if the initial CV exceeds 1.5, and the WACC is reduced by 0.5% if the CV is 0.75 or less. Then a revised NPV is calculated. What WACC should be used for this project when project risk has been properly considered? What are the revised values for the NPV, standard deviation, and coefficient of variation? Would you recommend that the project be accepted? Why or why not?

Probability

Unit Sales

Variable Cost

Best Case

25%

4,800

65%

Base Case

50%

4,000

70%

Worst Case

25%

3,200

75%