Nasco Heating Inc., a producer of heating equipment in Michigan, is currently evaluating the introduction of a new infrared space heater. Several of Nasco's competitors have already entered the quartz infrared market in response to the public's demand for heating devices that provide soft, moist, safe heat without reducing oxygen and humidity in the heated area. As a result, industry analysts predict high growth in the sales of infrared heaters in the years to come.
Production facilities for the proposed project will be housed in a currently unused section of Nasco's plant; this section was renovated last year at a cost of $150,000. Another local company has asked to lease this section of Nasco's plant for $120,000 a year. The required production machinery costs $600,000; its shipping cost is estimated to be $10,000, while its installation cost is $40,000. The machinery falls in the 3-year MACRS class, has an economic life of four years, and its salvage value is estimated to be $100,000 after four years of use. In addition, Nasco must increase inventories by $120,000 at the time of the initial investment in the machinery. Thereafter, inventories should be three percent of annual revenues over the life of the project.
Nasco expects to sell 400,000 units of the new heater in the first year of operations; thereafter unit sales are estimated to grow at a two percent annual rate. If the project is undertaken, production costs and selling price would be $48 and $55 per heater, respectively at current (t = 0) dollars; nevertheless, Nasco estimates that price will increase at the five percent inflation rate while production costs will increase by only two percent annually beginning immediately.
Nasco's sales manager is concerned that the introduction of the infrared heater will cannibalize the sales of the firm's existing technology (i.e., radiant and ceramic) heaters. She estimates that existing heater sales will decline by $2,000,000 in the first year, dropping by an additional two percent annually thereafter. As a result, Nasco's production manager estimates that existing heater production costs will decline by $500,000 in the first year, falling by an additional one percent annually thereafter.
QUESTION
1. From past experience, you know that Nasco's management is interested in the different scenarios under which the project's NPV will be zero; i.e., the project will break even in terms of NPV. To be prepared, you would like to consider the following scenarios:i. All else the same, at what year 0 price per heater would the project break even? ii. All else the same, what is the sales volume (in heaters) in each of the next four years for which the project will break even?
2. You also want to prepare calculations for the following alternative scenarios regarding the impact of inflation on the price and production cost per heater: i. All else the same, what is the project's NPV if production costs increase annually at the 5% inflation rate instead of the 2% rate? ii. All else the same, what is the project's NPV if production costs increase annually at the 5% inflation rate but the price per heater increases 2% annually?
3. You also expect management to inquire about the impact of t = 4 machinery salvage value, t = 1 sales in heaters, and the discount rate on your calculations. Perform sensitivity analysis for the project's NPV with respect to these three input variables assuming each one deviates from its base case level by ± 10%, 20%, 30%. Tabulate and plot your results and describe your findings and their implications.
4. Based on your calculations for 5 above, management appears to be concerned with the base case (or average) sales of 400,000 heaters at t = 1 and ask for more detailed information regarding possible sales scenarios. The sales manager is present in the meeting and provides the following information: Demand for infrared heaters Low Average High Sales in heaters 100,000 400,000 700,000 Probability 0.25 0.50 0.25 Provide NPV calculations for the project under these three scenarios and address management's concerns.
5. Nasco's CFO is also present at the meeting and wonders whether the discounting rate for the infrared heater project will be the firm's 12 percent WACC. He explains that he checked the infrared heater projects undertaken by Nasco's competitors and found that such projects have used a discounting rate which, on average, exceeds the firm's WACC by 4.5 percent, suggesting higher risk for such projects. All else the same, how would this information impact your calculations for the base case NPV