Webmasters.com has developed a powerful new server that would be used for corporations” Internet activities. It would cost $10 million to buy the equipment necessary to manufacture the server, and it would require net operating working capital equal to 10 percent of sales. The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. After the first year the sales price and variable costs will increase at the inflation rate of 3 percent. The company”s fixed costs would be $1 million per year and would increase with inflation. It would take 1 year to buy the required equipment and set up operations, and the server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. Also, the project”s returns are expected to be highly correlated with returns on the firm”s other assets. The firm believes it could sell 1,000 units per year.
The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of the equipment at the end of the project”s 4-year life is $500,000.
Web masters” federal-plus-state tax rate is 40 percent. Its cost of capital is 10 percent for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 and 1.2. Low-risk projects are evaluated with a WACC of 8 percent, and high-risk projects at 13 percent.
a. Develop a spreadsheet model and use it to find the project”s NPV, IRR, and payback.
b. Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and number of units sold. Set these variables” values at 10 percent and 20 percent above and below their base-case values. Include a graph in your analysis.
c. Now conduct a scenario analysis. Assume that there is a 25 percent probability that “best case” conditions, with each of the variables discussed in part b being 20 percent better than its base-case value, will occur. There is a 25 percent probability of “worst-case” conditions, with the variables 20 percent worse than base, and a 50 percent probability of base-case conditions.
d. If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and payback.
e. On the basis of information in the problem, would you recommend that the project be accepted?
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