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ECF6110 Business Finance

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Question:

1.The accountant’s estimates in Exhibit 3 use the “most likely” sales projection in Exhibit 1 for each year. Are any of the 11 items listed in Exhibit 3 incorrect for application of the net present value (NPV) method? Have any relevant items been omitted from the list? Consider all information given in the case and explain why.
 
2.Prepare the incremental cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) for the project over the eight years based on the “most likely” sales projection of 1,650,000 pounds per year in Exhibit 1.
 
3.Based on your estimated after-tax net cash flows in Question 2, calculate the payback period, NPV, internal rate of return (IRR) and profitability index (PI) of this project. Assume DP uses a payback rule with cut-off period of five years and the appropriate after-tax discount rate is the company’s cost of capital. Should the project be undertaken based on each of the investment evaluation methods?
 
4.Show a sensitivity analysis of NPV to sales quantity (worst- and best-case scenarios)
 
5.Use the NPVs for the worst-, most-likely- and best-cases of sales quantity estimates (i.e. the figures derived in Questions 3 and 4), and their probabilities of occurrence to find the project’s expected NPV, standard deviation, and coefficient of variation.
 
6.Recall that Walker is quite sceptical of the salesmen’s estimate of the new sales as a result of internal production of the 10-in. and 12-in. pipe. To help him in the evaluation, Walker is interested in the minimum annual increase in new sales necessary to make the project worthwhile. What is this figure assuming equal annual sales? [You may assume that (1) only materials and distribution costs will vary with increased production; (2) no additional equipment is needed; (3) unit selling price is 56 cents per pound; and (4) the relevant after-tax discount rate is 12 percent.]
 
7.Walker used a 12% discount rate to find the present value of annual cash flows caused by any increase in the unit sales of 3-in., 6-in., and 8-in. pipe. He believes this should be 13% and may be even as high as 15%. Does it make sense to use a higher discount rate in Question 6 than in Question 3? How important is this “interest rate concern” to the project if the expected rate of inflation is 3% per year? Justify your answer.
 
8.Based on your answers to Questions 1 – 7 above and other information in the case, what do you recommend? Do you recommend in-house production of the 10-in. and 12-in. pipe?  Defend your advice with the support of your answers.
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