Harris Inc is planning to develop a powerful new server for Internet activities. It will cost $5 million to buy the equipment necessary to manufacture the server, and $1 million of net working capital will be required for start-up. The servers will sell for $16 per unit, and managers believe that variable costs would amount to $11 per unit. Managers also believe that in the first year they will sell 500,000 units and unit sales will increase by 4% per year. With sales volume increasing, the firm plans to increase net working capital for the project by 1% per year to support sales. The project's fixed costs will be about $700,000 per year. The server project will have a life of 6 years. The equipment will be depreciated over a 7-year period using MACRS rates. The estimated market value of the equipment at the end of the project's 6-year life is $250,000. Harris Inc's federal-plus-state tax rate is 40%. In addition, the firm has a debt-equity ratio of 60%. The cost of equity is 13.50% and the after-tax cost of debt is 7.50%. The firm does not issue preferred stock. The project will be funded by issuing new bonds and new shares of stock. Harris Inc believes its flotation costs for its stock is 8.50% and the flotation costs for its bond is 2.50% of the amount issued.
A. Develop a spreadsheet in Microsoft Excel and use it to find the project's NPV, IRR, MIRR and PI. (Hint: use your notes and texts. Also, make sure every item is clearly labeled). Would you recommend that the project be accepted? Why or why not?
B. Create an NPV profile chart for Harris Inc.; let the discount rate (i.e., WACC) range from 0% to 20% in 1% increments (so you should have a total of 21 different discount rates. Briefly discuss the chart.
C. Conduct a sensitivity analysis to determine the sensitivity of your results to changes in the growth rate for number of units sold. Assume that the best case growth rate for unit sales is 6% and that the worst growth rate for unit sales is 2%. Briefly discuss your findings relative to the base case.
D. Now assume that there is a 25% probability that the "best case" condition will occur, a 25% probability that the "worst case" condition will occur, and a 50% probability that the "base case condition will occur. Using these estimates compute the Expected NPV, IRR, MIRR and PI and their standard deviations. Would you recommend that the project be accepted? Why or why not?
E. Now create a new spreadsheet with the base case from Part A. Use the "Solver" program in excel to answer the following questions about the project's break-even points.
i. All else being constant, how low can unit sales in the first year be before the project starts losing money (hint: this is the financial break-even point for the project)?
ii. All else being constant, what is the lowest possible price that managers could charge per unit before the project starts losing money (this is another useful break-even point)?
iii. All else being constant, what debt-to-equity ratio would make the NPV of the project is zero?
iv. Write one short paragraph summarizing the implications of these break-even points in the decision to accept or reject this project.
F. Now assume that a few friends point out to you that the risk associated with the new project is significantly different from that of the firm. Moreover, they inform you that the CEO plans to finance the project with 50% debt and 50% equity. As a result, you decide to compute a risk-adjusted discount rate to evaluate the project based on the project's beta (i.e., a project specific discount rate based on CAPM).
You think that the risk-free rate of return is about 2.50%, and that the market risk premium is about 6.24%.
To compute the project's equity-beta, you located the following 5 companies with operations similar to the proposed project:
Company A has an equity beta of 2.25 and is financed 25% by debt and 75% by equity.
Company B has an equity beta of 2.00 and is financed 40% by debt and 60% by equity.
Company C has an equity beta of 1.60 and is financed 50% by debt and 50% by equity.
Company D has an equity beta of 1.30 and is financed 15% by debt and 85% by equity.
Company E has an equity beta of 2.50 and is financed 45% by debt and 55% by equity.
i. Compute the project-specific discount rate. Compare and contrast the project-specific discount rate to the WACC.
ii. Using the project-specific discount rates, re-estimate the project's NPV. Would you recommend that the project be accepted? Why or why not?
iii. Briefly discuss the benefits of using the CAPM-derived project-specific discount rate relative to the firm's WACC.