Your boss has assigned you as Project Analyst for a new project in your company’s pipeline. Your main task is to evaluate the merits of this project and determine if the company should proceed with the project. Analysts within the firm have already prepared projections for the project that you are to use in your analysis. The information is provided below:
The firm has already invested $20 million in research and development for the project.
If the project proceeds forward, there is an expectation that an additional $50 million will need to be invested in R&D. However, these R&D costs have a normal distribution and the standard deviation is expected to be $12 million. These costs are all expected to occur this business year and can be treated as if they occur at the end of the year.
The firm has already negotiated the construction of the plant and machinery necessary to begin production of the product. The cost will be $170 million. However, built into the contract are certain criteria that may increase the cost by 20%. The firm estimates the probability of these criteria occurring to be 35%. $60 million of this will be paid upfront, with the remainder being paid on completion.
The construction will start immediately, but the length of time needed is unknown. It is estimated to follow a uniform distribution with a minimum of 1 year and maximum of 3 years.
Once construction is completed, production cannot begin until permitting is completed. Permitting will follow a lognormal distribution with a mean of six months and standard deviation of 3 months.
As soon as permitting is cleared, production of the product will begin. There will be an immediate need to initiate working capital at an expected amount of $45 million. This amount will follow a normal distribution with a standard deviation of $7 million.
The product’s life will be eight years.
For each year the product is sold (All can be assumed to occur at the end of each year.):
The number of units sold is expected to be 750,000. This will follow a normal distribution with a standard deviation of 18,000 units. Each year
The price is expected to be $400 per unit. However, this will follow a normal distribution with a standard deviation of $25 per unit.
Variable costs will follow a normal distribution with an expected value of 66.4% and a standard deviation of 4.1%. However, the min possible variable cost is 51.6%.
Fixed costs are expected to be $21.5 million annually. This will follow a normal distribution with a standard deviation of $1.7 million. However, due to existing contracts, the minimum level is $20.1 million.
Number of units, price per unit, variable cost per unit, and fixed costs should vary by year. In other words, each year should have its own unique distribution.
The initial cost of the plant will be depreciated using straight-line over the first four years. The assumed salvage value at the end of the project will be zero.
The firm’s marginal tax rate is 35%.
Working capital is expected to have a mean of $50 million with a standard deviation of $12 million starting with year 1.
All working capital will be recouped immediately at the end of the project.
The firm’s Weighted Average Cost of Capital is 10.4%. However, your boss has asked you to include an additional risk adjustment of 1.2% due to the higher level of risk associated with this new project.
First, find the NPV ignoring distributions and using only means (or most likely values).