Use your company’s expected return as the cost of equity capital (that is the required expected return on the stock in the market from c.1) as the required return (or discount rate) to evaluate the following capital budgeting proposal for your company:

            A proposal to build an $1.5 billion factory is being contemplated to produce a new product that will utilize land currently owned by your company (that has a current book value of $10 million and could be sold for that amount today). The $1.5 billion factory is expected to last 20 years (but can be completely depreciated immediately according to current accounting rules), and it along with the land is expected to be sold for $100 million at the end of the 20-year useful life. The factory is expected to produce 110,000+U units per year that are forecast to be sold for a price of $29,000 each. Variable costs (production labor, raw materials, marketing, distribution, etc.) are predicted to be $26,000 per unit. Fixed costs (administration, maintenance, repairs, utilities, insurance, real estate taxes, etc.) are expected to be $68+U million per year. The tax rate is 21%. The project will require $97 million in inventory (raw materials and finished products) as well as $61+U million in receivables (credit for customers). An extra $50+U million in cash (i.e., precautionary bank deposits and short-term marketable securities held as liquidity reserves) is required as a safety stock to provide financial flexibility (that enables avoiding running out of cash in case of temporary declines in operating cash flows). Suppliers (companies which sell the parts and raw materials that are used in the production of the 110,000+U units produced by the factory) are expected to provide short-term trade credit that is expected to sum to $36 million in accounts payable while short-term accrual financing of $21 million is supplied by the employees (who don’t get paid until the end of the month)

  1. Compute the NPV based on the above initial forecasts
  2. Compute the IRR
  3. Indicate the change in shareholder wealth (i.e., the increase or decrease in the company’s equity market capitalization) that would occur as a result of undertaking this project
  4. Determine if the project should be undertaken
  5. Compute the Payback Period (and reevaluate the project if the company requires a Payback Period of 5 years)
  6. Compute equivalent annual cash flow (EAC) of the project evaluated in d.1 and compare that to another project involving the manufacture of a mutually exclusive alternative product that has been developed and that would have an annual EAC of $14 million if it were put into production (using a factory that would last 22 years before being replaced) and re-evaluate the project in d.1 in a recurring context.
  7. Compute the NPV if demand is only 50,000+U units per year expected (but everything is the same as initially forecast).
  8. Compute the NPV if both the variable and fixed costs are 10% higher than initially expected (but everything is the same as originally forecast).
  9. Compute the sensitivity of NPV to a change in unit sales
  10. Compute the minimum sales price per unit to get an NPV of at least $0
  11. Compute the NPV if prices and all costs were expected to rise by 2.2% per year due to expected inflation (helpful hint: use the growing annuity formula for the annual after-tax cash flow; or you could use the given fixed nominal numbers but discount them at the real cost of capital)
  12. Assume that, if you undertake the project, you can alternatively install a different energy system that is more environmentally friendly energy system (e.g., green hydrogen or fuel cells) that requires an incremental investment of $24 million and is expected to initially lead to incrementally higher energy costs (that reduce after-tax cash flows by $3 million per year for the first 5 years of the project) but result in incrementally lower energy costs thereafter (that increase after-tax cash flows by $8 million per year from year 6 through year 20 of the project). Compute the incremental NPV of this alternative energy system
  13. Evaluate any ethical considerations involved in making the decision in d.12.
  14. Indicate the effect on the NPV computed in d.1 if your company had previously (over the last few years) spent $14 million to research and develop the product that your company is now evaluating producing.
  15. Compute the effect on the NPV in d.1 if your company needs to issue new shares of stock to fund the investment and the flotation costs of selling those new shares is 8% (and decide whether the project should or shouldn’t be undertaken if such sales of new shares of stock need to be made to fund the investment).

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