Question: Webmasters.com has developed a powerful new server that would be used for corporations' Internet activities. It would cost $10 million to buy the equipment necessary to manufacture the server in 2017; another $10,000 in shipping charges would be required; and it would cost an additional $30,000 to install the equipment.
Webmasters.com decided to finance the new project by bank loan. Interest payments are made annually at an annual rate of 5% with equal end-of-year payments over 7 years. The equipment would be installed in a building owned by the firm and located in Los Angeles. This building, which is vacant now, and the land can be rented for $20,000 annually before taxes. The project would require net working capital at the beginning of each year equal to 10% of sales.
The servers would sell for $20,000 per unit, and Webmasters believes that variable costs would amount to $10,000 per unit. After 2018, the sales price and variable costs would increase at the inflation rate of 3%. The company's nonvariable costs would be $1 million at 2017, and would increase with inflation. The server project would have a life of 7 years. If the project is undertaken, it must be continued for the entire 7 years. Also, the project's returns are expected to be highly correlated with returns on the firm's other assets. The firm believes it
could sell 2,000 units per year. The equipment would be depreciated over a 9-year period, using MACRS rates.
The estimated market value of the equipment at the end of the project's 7-year life is $500,000. Webmasters' federal-plus-state tax rate is 30%. Its cost of capital is 10% for average risk projects. Low risk projects are evaluated with a WACC of 7%, and high risk projects at 13%.
A. Develop a spreadsheet model and use it to find the project's NPV, IRR, and payback.
B. Suppose you believe that the accounting department's equipment cost, salvage value, variable cost, and fixed costs projection are accurate within ±15 %; the marketing department's price and quantity are accurate to within ±10 ; and the given for price. Now evaluate the riskiness of this project to the possible changes in equipment cost, salvage value, variable cost, fixed costs, selling price, and
quantity. Include a graph in your analysis.
C. Conduct a scenario analysis. Assume that there is a 25% probability that "best case" conditions, with each of the variables discussed in Part B being 20% better than its base case value, will occur. There is a 25% probability of "worst case" conditions, with the variables 20% worse than base, and a 50% probability of base case conditions.
D. Based on the information in the problem, would you recommend that the project be accepted? Explain.