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Solution Library
Calculation Of NPV, IRR, Payback, Discounted Payback And Profitability Index
Question
The Widget Project
By Gary Moore, PH.D., J.D.
After extensive research and development, Your company has recently developed a new Widget and must decide whether to make the investment necessary to produce and marketing it. The widget is superior to current widgets in the marketplace. Research and Development costs have been $20 million so far. The product would be put on the market at the beginning of this year. We anticipate that test marketing the project will cost $1 million dollars. The plant will be in a building that we bought for $2 million dollars 30 years ago but a competitor who would like to buy our business offered us $3.5 million for the property a year ago. The property has a current book value of 5 million dollars due to renovation we did 5 years ago. We tried to sell the building this year for 4.5 million, but received no offers.
As a Financial Analyst you have been called in to do the evaluation of the project and to provide a recommendation. The Company must invest $150 million in new money for equipment. The equipment can be sold for $55 million at the end of five years. The appropriate deprecation schedule for the new equipment is the seven year MACRS depreciation schedule. The immediate initial working capital requirement is 15 million dollars. Thereafter the net working capital will be 15 percent of sales. General Administrative expenses are expected to be $25 million a year the first year and expected to increase with inflation each year. Annual expected inflation is expected to be 3.25 percent. The widgets are expected to sell at 40 dollars while the cost to produce each widget is 20 dollars. The market for widgets is currently 33 million and is expected to increase by 1 percent each year. Our estimated share will be 10 percent and increase by ½ a percent each year of the project. We expect to be able to pass any effects of inflation to our customers since the market is not overly competitive. The company’s tax rate is 35 percent. The project is expected to end in 5 years.
You are to use at least three discount rates to evaluate the project. Calculate the NPV, the payback, the discounted payback, the IRR and the PI on the project.
First use the WACC of your company that you chose using the current market weights as the optimal capital structure. Make sure that you use multiple methods to calculate the cost of equity and discuss how you came up with the final cost of equity. What risk-free rate is appropriate? What is the market risk premium that is appropriate? Discuss the options and justify your selection. Second, assume that the current capital structure is not optimal but a target capital structure using 35 percent debt is optimal.
Finally, assume that there is a question about your use of the patented process concerning Widget production and there is the possibility of litigation if you produce the Widget. Your consultant, Dr. Moore estimates that a risk premium of an additional 2 percent should be sufficient to cover the litigation risk.
Summary
The question belongs to Finance and it discusses about calculation of NPV, payback, discounted payback, IRR and profitability index of a project.
Total Word Count 418
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