Problem 5 (25 Points)

Arsenault Casting Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Bill Morse, a recent MBA graduate. The production line would be set up in unused space in the main plant. The machinerys invoice price would be approximately $200,000, another $10,000 in shipping charges would be required, and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 4 years, and Arsenault has obtained a special tax ruling that places the equipment in the MACRS 3-year class life. The machinery is expected to have a salvage value of $25,000 after 4 years of use.

The new line would generate incremental sales of 1,000 unites per year for 4 years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are both expected to increase by 3% per year due to inflation. Further, to handle the new line, the firms net working capital would have to increase by an amound equal to 12% of sales revenue. The firms tax rate is 25%, and its overall weighted average cost of capital, which is risk-adjusted cost of capital for an average project is 10%.

1. Assume the plant space could be leased out to another firm for $25,000 per year.
2. Assume that the new line would decrease sales of the firms other products by $50,000 per year and the cost of goods sold for those products would have been $25,000.
3. Please find the NPV, IRR< MIRR, PI, payback period and discounted payback period for this project.
4. Perform a sensitivity analysis on the cost per unit, unit sales, and salvage value. Assume changes of 10%, 20%, and 30% and include a graph and discuss your results.
5. Assume that Bill Morse is confident in all of the variables except unit sales and sales price. Here is what he thinks: If product acceptance is poor only 800 units would be sold per year and unit price would dip to $160; if there is a strong response to this product unit sales could rise to 1200 and price increase to $240 per unit. Bill believes the probabilities associated with these scenarios are a 25% chance of poor acceptance, 50% chance the original base case would happen and a 25% of the strong response. Please perform a Scenario Analysis for this project.
   1. What are the NPVs for Poor, Base and Strong cases?
   2. What is the expected NPV?
   3. What is the standard deviation of NPV?
   4. What is the coefficient of variation for this project?
6. Assume the companys coefficient of variation for an average project is in the range of 0.2 to 0.4, how would you classify the risk of this project? Low? Average? High?
   1. If Arsenault normally adjusts WACC by 3% to adjust for risk. What is the appropriate WACC for this project and what is the risk adjusted NPV?
7. Should Arsenault accept this project?