Project Valuation HMG Corporation is considering the manufacture of a new chemical compound that is used to make high-pressure plastic containers. An investment of $4 million in plant and equipment is required. The firm estimates that the investment will have a five-year life, and will use straight-line depreciation toward a zero salvage value. However, the investment has an anticipated salvage value equal to 10% of its original cost.
The number of pounds (in millions) of the chemical compound that HMG expects to sell over the five-year life of the project are as follows: 1.0, 1.5, 3.0, 3.5, and 2.0. To operate the new plant, HMG estimates that it will incur additional fixed cash operating expenses of $1 million per year and variable operating expenses equal to 45% of revenues. HMG also estimates that in year t it will need to invest 10% of the anticipated increase in revenues for year t + 1 in net working capital. The price per pound for the new compound is expected to be $2.00 in years 1 and 2, then $2.50 per pound in years 3 through 5. HMG’s tax rate is 38%, and it requires a 15% rate of return on its new-product investments.
Replicate the NPV and IRR calculations using the included Excel template.
What are the key sources of risk that you see in this project?
Use the Goal Seek function in Excel to find the breakeven values (i.e., values that force the project NPV to equal zero) for each of the following variables: the initial CAPEX, the working capital percentage of revenue growth, variable cost percentage of sales, and sales volume. (Hint: Scale the sales volume for all five years up and down by the same percentage.)
Which of the variables analyzed in Problem 3-5(b) do you think is the greatest source of concern? What, if anything, could you do to reduce the risk of the project?
Should you always seek to reduce project risk?