P12-3 Breakeven cash inflows and risk Blair Gasses and Chemicals is a supplier o

Question

P12-3 Breakeven cash inflows and risk Blair Gasses and Chemicals is a supplier of highly purified gases to semiconductor manufacturers. A large chip producer has asked Blair to build a new gas production facility close to an existing semiconductor plant. Once the new gas plant is in place, Blair will be the exclusive supplier for that semiconduc- tor fabrication plant for the subsequent 5 years. Blair is considering one of two plant designs. The first is Blair's "standard" plant, which will cost $30 million to build. The second is for a "custom" plant, which will cost $40 million to build. The custom plant will allow Blair to produce the highly specialized gases that are required for an emerg- ing semiconductor manufacturing process. Blair estimates that its client will order $10 million of product per year if the traditional plant is constructed, but if the cus- tomized design is put in place, Blair expects to sell $15 million worth of product annu- ally to its client. Blair has enough money to build either type of plant, and, in the absence of risk differences, accepts the project with the highest NPV. The cost of capital is 12% a. Find the NPV for each project. Are the projects acceptable? b. Find the breakeven cash inflow for each project c. The firm has estimated the probabilities of achieving various ranges of cash in flows for the two projects as shown in the following table. What is the probability that each project will achieve at least the breakeven cash inflow found in part b? Probability of achieving cash inflow in given rangc Range of cash inflow (S millions) Standard Plant Custom Plant $0 to $5 $5 to $8 $8 to $11 $11 to $14 $14 to $17 $17 to $20 Above $20 0% 5% 10 60 25 5 0 10 25 20 15 d. Which project is more risky? Which project has the potentially higher NPV? Discuss the risk-return trade-offs of the two projects. e. If the firm wished to minimize losses (that is, NPV

Explanation / Answer

(a.)

Let standard plant be PROJECT A and custom plant be PROJECT B.

PV OF INFLOWS (B*C) (D)

NPV

(D-A)

Yes, the projects are acceptable as the NPV is positive for both the projects.

(b.) Breakeven cash inflow is where the NPV is zero. Assuming the cash inflow per year to be x, we can find the value by equating inflow(x) multiplied by PV annuity factor to the total initital inflow.

Standard plant: x*3.605 = $30 million

   x = 30/3.605 = $8.32 million

Custom plant: x*3.605 = $40 million

x = 40/3.605 = $11.09 million

(c.)

For the standard and custom plant the probability that it will atleast achieve the breakeven cashflow is the sum of following:

For standard, ranges $0-$5 and $5-$8 and for custom, ranges $0-$5, $5-$8 and $8-$11 are not considered because they are less than the breakven cash inflow.

d. Custom project is riskier as the probablity of achieving breakeven inflow is 70% compared to the probability of 90% of the standard project.

Custom project has potentially higher NPV as the probabilty of inflow above $14 is 45%(20+15+10) compared to that of just 5%.

e. If the company wants to minimize losses then it should go for the standard plant (project A) because the probabilty of NPV being negative is just 10% while in custom plant (project B) it is 30%.

If the company wants a higher NPV then custom plant (project B) should be selected because it has a very high probability of getting higher NPV as compared to standard plant (project A).

PROJECT INITIAL OUTFLOW (A) INFLOW PER YEAR (FOR 5 YEARS) (B) PV ANNUITY FACTOR @ 12% (C)

PV OF INFLOWS (B*C) (D)

NPV

(D-A)

A $30 MILLION $10 MILLION 3.605 $36.05 MILLION $6.05 MILLION B $40 MILLION $15 MILLION 3.605 $54.075 MILLION $14.075 MILLION

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