When preparing capital budgeting analysis for a new project, Chris Johnson, a ch

Question

When preparing capital budgeting analysis for a new project, Chris Johnson, a chief financial officer at BT Industries, faced a dilemma. The project involved a production of new type of shipping containers, which were significantly more durable and had a considerably longer useful life compared to conventional containers used in the industry. The year was 2009, and the equipment necessary for producing the containers was being sold for $700K. Each year, this cost is expected to increase by 20%. The useful life of the equipment and the project is 5 years. Mr. Johnson estimated that during a good year, the project will generate net cash flows of $500K per year, while during a bad year, the project will lose money, with an expected net cash flow of $-100K per year.

Because the economy suffered a significant decline just a year prior, there was uncertainty about the economy in general, and, very much affected by the economy, the demand for shipping and containers. Market analysts predicted that 2010 provide certain information about the likelihood of recovery. At this point, in 2009, the likelihood of 2010 being a good year is estimated at 40% and the likelihood of 2010 being a bad year is estimated at 60%. If 2010 is a good year, the likelihood of subsequent 2011 and on being good years (recovery) is 80%, and the likelihood of these subsequent years being bad years (recession) is 20%. If 2010 is a bad year, the likelihood of subsequent 2011 and on being good years (recovery) is 20%, and the likelihood of these subsequent years being bad years (recession) is 80%. In 2011, the situation will get resolved, and everyone will know whether subsequent years are good or bad with certainty. Since he has not dealt with uncertainty regarding the future state of the economy before, Mr. Johnson is bewildered and asks your help in determining the course of action regarding this opportunity. In particular, should the firm buy the equipment in 2009, 2010, or not buy at all? Mr. Johnson has estimated that the WACC for the company in certain times has been 10%. Assume that the project has no tax implications, i.e. the tax rate of 0%. Also assume that the firm can shut down the project any time at no cost.

Question: What is the PV of the project and should the firm buy the equipment in 2009, 2010, or not buy at all?

Explanation / Answer

because it generate no profit for the company.

Calculation of PV of the project & the decision regarding buy and not buy the equipments Particulare 2009 2010 Initial investment(a)          700,000.00       840,000.00 Cash inflow On good year(500000)          454,500.00       165,200.00 On bad year(-100000)          (90,900.00)       (49,560.00) total cash in flow (b)          363,600.00       115,640.00 Net present Value if the project        (336,400.00)    (724,360.00) (a)-(b) the present value of the project during 2009 is (336400) and during 2010 is (724360) both year the NPV show negative result there for it is good that not to buy the equipment at all

because it generate no profit for the company.

Working Notes cost of capital is 10% there for discount factor for 2009 =.909 2010 =.826 there for dicounted cash flow of 2009 if good year is =500000 X.909=454500 if bad year= -100000X.909 = -90900 the likelihood of being good in 2010 was 40% being bad in 2010 is 60% there for cash flow in 2010 if it is good =200000 cash flow if it is bad =(60000) there for discounted cash flow if good= 200000X.826 =165200 if bad = -60000 X.826 =49560

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