A Canadian firm is evaluating a project in the United States. This project invol
ID: 2711393 • Letter: A
Question
A Canadian firm is evaluating a project in the United States. This project involves the establishment of a lumber mill in Wisconsin to process Canadian timber. The factory expects to service clients in the construction industry. All cash flow figures are in thousands. Initial Investment. The initial investment is CAD 30,000. The project is over a period of three years. This investment will be depreciated straight line to zero. Operating Results. The firm expects two equally likely scenarios for the first year of operations. Under the favorable scenario, the firm expects to produce and sell 1,100 units of a product. Under the unfavorable scenario, it expects to produce and sell only 700 units. The selling price is expected to be CAD 27; the variable expense is expected to be CAD 11, and fixed costs excluding depreciation are expected to be CAD 3,750. Additional Investment. If the firm encounters the favorable scenario during year 1, it could make an investment of CAD 20,000 to enable it to produce and sell a total of 2,500 units (additional units is 1,400) in the second and third years. The cost parameters remain unchanged with the exception of depreciation. This secondary investment will be depreciated equally in years 2 and 3. If the firm chooses not to make the investment in year 1, the results of year 1 will be repeated during years 2 and 3. Discount Rate and Miscellaneous. Assume a discount rate of 10 percent and zero taxes. a. Estimate the NPV of the project. b. Estimate the NPV of the option to expand
Explanation / Answer
(1) Under the unfavorable scenario:
Annual cash inflow =
Sale (700 x 27) 18900
Less: Variable expenses (700x11) 7700
Fixed cost 3750
Net annual cash inflow 7450
Year
Annual Cash Inflow Flow
Present value of annual cash inflow at 10 % discount rate
1
7450
6772.05
2
7450
6153.7
3
7450
5594.95
Total
18520.7
Thus net present value = 18520.7 – 30000 = – 11479.3
(2) Under the favorable scenario:
Annual cash inflow in first year:
Sale (1100 x 27) 29700
Less: Variable expenses (1100 x 11) 12100
Fixed cost 3750
Net annual cash inflow 13850
Annual cash inflow in Second & Third year:
Sale (2500 x 27) 67500
Less: Variable expenses (2500 x 11) 27500
Fixed cost 3750
Net annual cash inflow 36250
Year
Annual Cash Inflow Flow
Present value of annual cash inflow at 10 % discount rate
1
13850
12589.65
2
36250
29942.5
3
36250
27223.75
Total
69755.9
Thus net present value = 69755.9 – 50000 = 19755.9
Year
Annual Cash Inflow Flow
Present value of annual cash inflow at 10 % discount rate
1
7450
6772.05
2
7450
6153.7
3
7450
5594.95
Total
18520.7
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