Your company would like to increase its product lines. Two alternatives are avai
ID: 2716039 • Letter: Y
Question
Your company would like to increase its product lines. Two alternatives are available, a new line of outdoor smokers and a new line of outdoor grills. The two lines are mutually exclusive, meaning that only one of these investment alternatives can be selected. The projected cash flows and their respective probabilities for each alternative are given in the table. There are three possible levels of demand and their corresponding probabilities, which depend on the state of the economy.
Click here to download the table for Investment A.
The two alternatives carry equal risk and should be evaluated at the company's cost of capital. The cost for the new smoker line will be $7,000,000. Also, the company has been guaranteed a buyer for the new line at the end of the fifth year. The buyer has agreed to purchase the new line for $7,900,000. The outdoor grill alternative will cost $3,987,000 and also has a guaranteed buyer, who has agreed to pay $4,000,000 at the end of the fifth year.
Jorge has asked you to provide detailed responses to the following:
Management of Vanda-Laye has determined that the capital structure of the company will involve 30% debt and 70% common equity. This structure will be used to finance all investments by the company. Currently, the company can sell new bonds at par, with a coupon rate of 7%. Any new common stock can be sold for $45, with a required return (or cost) of 15.57%. Using Microsoft Excel, calculate the company's cost of capital to be used in the evaluation of possible investment projects.
For Investment A:
Using Microsoft Excel, create a decision tree. Indicate the various levels of demand and their respective probabilities. Also, include the calculations for the expected cash flows.
Calculate the expected NPV for each alternative. Explain the decision rules for making a selection between the two alternatives on the basis of the expected NPV.
Assuming the two alternatives are mutually exclusive, specify which alternative you would recommend to the company. Explain why.
If the two alternatives were independent of each other, specify which project you would select. Would you accept both projects if funding were available for both? Explain your answer.
Demand
Probability
Year 1
Year 2
Year 3
Year 4
Year 5
Outdoor Smoker
High
0.2
$800,000
$900,000
$1,000,000
$1,100,000
$1,500,000
Moderate
0.6
$500,000
$700,000
$800,000
$960,000
$1,240,000
Low
0.2
$200,000
$350,000
$500,000
$600,000
$750,000
Outdoor Grill
High
0.2
$600,000
$750,000
$850,000
$975,000
$5,160,000
Moderate
0.6
$450,000
$500,000
$700,000
$825,000
$4,980,000
Low
0.2
$150,000
$220,000
$370,000
$500,000
$4,750,000
Demand
Probability
Year 1
Year 2
Year 3
Year 4
Year 5
Outdoor Smoker
High
0.2
$800,000
$900,000
$1,000,000
$1,100,000
$1,500,000
Moderate
0.6
$500,000
$700,000
$800,000
$960,000
$1,240,000
Low
0.2
$200,000
$350,000
$500,000
$600,000
$750,000
Outdoor Grill
High
0.2
$600,000
$750,000
$850,000
$975,000
$5,160,000
Moderate
0.6
$450,000
$500,000
$700,000
$825,000
$4,980,000
Low
0.2
$150,000
$220,000
$370,000
$500,000
$4,750,000
Explanation / Answer
Cost of Capital = (7 x 0.3) + (15.57 x 0.7) = 12.999% round off 13%
The present values have been calculated as Cashflow / ((1 + Cost of Capital) ^ number of year)
The NPV is the sum of the present values of all the cashflows
The expected NPV is calculated as (High demand NPV x 0.2) + (Moderate demand NPV x 0.6) + (Low demand NPV x 0.2)
The decision rule for selection on NPV basis is the alternative with higher NPV is selected.
If the two alternatives are mutually exclusive then select Alternative of Outdoor Grill as it gives the higher Expected NPV.
If the two Alternatives are independent of each other then, both the alternatives can be selected if funding is available as both have positive Expected NPVs.
Outdoor Smoker: Expected NPV $5,424.09 Outdoor Grill: Expected NPV $2,584,819.61 High Demand with Probability = 0.2 High Demand with Probability = 0.2 Year Cashflow Cost of Cap Present Value NPV Year Cashflow Cost of Cap Present Value NPV 0 -7000000 13% -$7,000,000.00 $882,440.78 0 -3987000 13% -$3,987,000.00 $3,290,092.88 1 800000 13% $707,964.60 1 600000 13% $530,973.45 2 900000 13% $704,832.02 2 750000 13% $587,360.01 3 1000000 13% $693,050.16 3 850000 13% $589,092.64 4 1100000 13% $674,650.60 4 975000 13% $597,985.76 5 9400000 13% $5,101,943.40 5 9160000 13% $4,971,681.01 Moderate Demand with Probability = 0.6 Moderate Demand with Probability = 0.6 Year Cashflow Cost of Cap Present Value NPV Year Cashflow Cost of Cap Present Value NPV 0 -7000000 13% -$7,000,000.00 $94,732.48 0 -3987000 13% -$3,987,000.00 $2,667,910.72 1 500000 13% $442,477.88 1 450000 13% $398,230.09 2 700000 13% $548,202.68 2 500000 13% $391,573.34 3 800000 13% $554,440.13 3 700000 13% $485,135.11 4 960000 13% $588,785.98 4 825000 13% $505,987.95 5 9140000 13% $4,960,825.82 5 8980000 13% $4,873,984.23 Low Demand with Probability = 0.2 Low Demand with Probability = 0.2 Year Cashflow Cost of Cap Present Value NPV Year Cashflow Cost of Cap Present Value NPV 0 -7000000 13% -$7,000,000.00 -$1,139,517.75 0 -3987000 13% -$3,987,000.00 $1,630,273.00 1 200000 13% $176,991.15 1 150000 13% $132,743.36 2 350000 13% $274,101.34 2 220000 13% $172,292.27 3 500000 13% $346,525.08 3 370000 13% $256,428.56 4 600000 13% $367,991.24 4 500000 13% $306,659.36 5 8650000 13% $4,694,873.45 5 8750000 13% $4,749,149.44Related Questions
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