Estimate the project's operating cash flows. Assume the sales price will increase by a 3.5% annual inflation

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Question:

Estimate the project's operating cash flows. Assume the sales price will increase by a 3.5% annual inflation rate beginning from year 1 to year 2, and cash operating costs (variable per unit and fixed) will increase by a 3% annual inflation rate, also beginning from year 1 to year 2. Assume no other cash flows (net working capital, or salvage values) are affected by inflation. Of course, lease payments are impacted by inflation but only to the extent of the previously mentioned contractual escalation clause. What is the project's NPV, IRR, MIRR? Use 15% for the required rate of return. A spreadsheet should be used to answer this question

Case

Nelson’s Wellbeing Corporation is a successful medical supply and equipment company. Nelson’s customers include medical practices, nursing homes and hospitals of all sizes and types. The firm benefits from the swift growth in the globalization of supply chains and the world economy. Kailee Nelson, the corporate founder, is considering a push to modernize and expand a product that has been around for a long time. The R&D arm of the company, led by Constandina Ciulla, has recently developed what is basically a germicidal lamp that has been updated and fine tuned to be effective against the virus that causes Covid 19 while minimizing possible harm to humans from the lamp. This product should have demand from many health care companies and organizations and possibly a number of other organizations as well.

If the company decides to go forward with this project, an assembly facility will be located in buildings leased for $3.24 million annually. This lease payment is tax-deductible, paid at the beginning of each year, and has an escalation clause causing the lease payment to increase 2.9% annually over the life of the project. Thus, the lease payment at the beginning of year 1 will be $3.24 million and it will then increase by 2.9% annually thereafter. Equipment for the facility will cost $15.9 million including delivery and installation. Net working capital needs will be $2.12 million immediately to support the facility. Assume the net working capital will not be needed and returned at the end of the project’s seven-year economic life.

Equipment depreciation will be according to MACRS 5–year asset class (20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76% respectively for years one through six). The equipment is expected to have a salvage value of $2.5 million after 7 years of use.

Nelon’s Wellbeing Corporation expects to produce and sell each lamp at an initial price of $450 per unit. The facility’s annual maximum production capacity is expected to be 110,000 units during the 7-year economic life of the facility. The forecast is for actual production and sales to be 90,000 units annually. Fixed cash operating costs (not including depreciation and lease payment) are estimated to be $7.55 million annually and variable cash operating costs are estimated at $260 per unit. Nelson’s Wellbeing Corporation’s federal-plus-state effective tax rate is 26%. Assume that Nelson’s Wellbeing is able to take advantage of all tax shields (tax-deductible expenses).

Your task is to analyze this project. You must recommend acceptance or rejection and evaluate the project's acceptability using the net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR) criteria. Nelson’s Wellbeing’s weighted average cost of capital and thus the project’s required rate of return is 15%.

William Thomas, the CFO, wondered whether it would be appropriate to assume neutral inflation equal to the 3.5% expected general rate of inflation, and if not, how sensitive the results would be to alternative assumptions of differential inflation impacts on revenues and costs. William expects these and other questions to be raised when you present your recommendations to the Executive Committee.

In addition to the basic capital budgeting analysis, William would like you to perform a risk analysis on the new capital budgeting project. The project appears to be profitable, but what are the chances that it might nevertheless turn out to be a loser, and how should risk be analyzed and worked into the decision process?

You met with Neomi Kadr of engineering and John Cabico from marketing to get a feel for the uncertainties involved in the cash flow estimates. After several sessions, you concluded the greatest uncertainty involved unit sales, variable cash operating costs and salvage value. Unit sales and the variable cost of production could vary widely, and the realized salvage value could be quite different from the estimates.

As estimated by Neomi’s marketing staff, if product acceptance is "normal" (base case), then sales quantity during the life of the project would be 90,000 units annually. If acceptance is “poor” (worst case), then only 75,000 units would be sold annually during the life of the project; and if consumer response is “strong” (best case), then the sales volume would be 105,000 annually during the life of the project. In any case, the price is expected to be kept at the forecasted level. In all cases, the price would probably increase in each successive year at the inflation rate (currently estimated to be 3.5%); while variable cash operating costs per unit and fixed cash operating costs would both increase in each successive year at a 3.0% rate.

As estimated by John’s staff, the equipment’s salvage value at the end of 7 years could be as low as $0.5 million and as high as $4.5 million. If product acceptance is low (worst case), the equipment’s salvage value will likely be about $0.5 million. If product acceptance is high (best case), the equipment’s salvage value will likely be about $4.5 million. If product acceptance is normal, then salvage value is expected to be $2.5 million.

Nelson’s Wellbeing Corporation’s Executive Committee requires that all sensitivity analyses consider changes in at least the following variables: unit sales, unit sales price, unit variable cash operating costs, fixed cash operating costs, and salvage value. The lease payment is fixed by contract so there is no reason to include the lease payment in the sensitivity analysis. Company policy also mandates that each of the variables be allowed to deviate from its expected value by plus or minus 5%, 10%, 15%, 20%, 25, and 30% in such an analysis.

In the past, William had scenario analyses performed on proposed capital budgeting projects in order to measure project risk with a coefficient of variation. He is considering the use of Monte Carlo simulations to estimate the coefficient of variation on future projects. From experience, William considers projects with coefficients of variation between 0.40 and 0.80 to be average risk projects. Projects outside this range would have the required rate of return adjusted up by 4% for high-risk projects and 4% down for low-risk projects.

You have been hired to perform the basic capital budgeting analysis and then to introduce the concepts of inflation and risk into the analysis. William plans to include a comprehensive risk analysis. Your task is to help him perform these analyses and to write up a report so he can make a recommendation to the Executive Committee.