ECON 106F Lecture Notes - Lecture 12: Operating Leverage, Tax Deduction, Net Present Value
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Final Project Scenario
You are an economist for the Vanda-Laye Corporation, which produces and distributes outdoor cooking supplies. The company has come under new ownership and management and will be undergoing changes in its product lines and operating structure. As an economist, your responsibilities include examining the market factors that affect success or failure of a product, including the supply and demand for the product, market conditions, and the behavior of competitors with similar products.
The new management has identified several possible investments for the coming year. It has asked you and your team to evaluate the possibilities and make a recommendation to the board of directors. Jorge has identified two mutually exclusive opportunities (Investment A) and two independent opportunities (Investment B) and assigned you the task of making a recommendation on the investments.
Investment A
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. (Table Below)
Investment A
| 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 |
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.
Investment B
Investment B involves two independent investment opportunities. The decisions on these two investment alternatives are also independent of Investment A. Investment B-1 involves a new packaging machine, which will eliminate the need for a local firm for packaging Vanda-Laye's products. The cost of this machine will be $24,000, and the expected revenues from this opportunity are given in the table and are considered to be of average risk. Investment B-2 is the purchase of a new computer system that will allow the company to sell its products on the Internet worldwide. The cost of this new system will be $29,000, with the expected cash flows after taxes given in the table.
Click here to download the table for Investment B. (Table Below)
Investment B
| Year | Cash Flows | |
| Packaging Machine | Computer System | |
| 1 | $8,400 | $9,100 |
| 2 | $4,800 | $8,800 |
| 3 | $7,800 | $8,300 |
| 4 | $6,200 | $8,000 |
| 5 | $5,500 | $5,100 |
| 6 | $4,600 | $4,000 |
| 7 | $3,000 | $3,500 |
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.
For Investment B:
Using Microsoft Excel, calculate the NPV for each alternative.
Using the decision-making criteria for the NPV, specify which alternative you would select if the two alternatives were mutually exclusive. Explain your answer.
Given that the two alternatives are independent of each other, specify which investment you would select, if not both. Explain your answer.
Using Microsoft Excel, calculate the IRR for each investment.
Using the decision-making criteria for the IRR, specify which alternative you would prefer. Explain your answer.
If funding were available, specify whether you would select both investments. Why or why not?
Calculate the profitability index (PI) for the two investments. Which project is preferred?
Determine whether there is a ranking conflict present in terms of the IRR and the NPV. Explain your answer. If a conflict does exist, explain how you would resolve the situation.
Submission Details:
Compile a report including all your responses from Weeks 1, 3, and 5. Make sure your report reads as one report rather than three reports pasted together. Complete all revisions suggested by your instructor in previous weeks. Make sure all responses are complete and accurate, supported by references and documented examples. The report should be 10â15 pages in length and include an executive summary.
You are an economist for the Vanda-Laye Corporation, which produces and distributes outdoor cooking supplies. The company has come under new ownership and management and will be undergoing changes in its product lines and operating structure. As an economist, your responsibilities include examining the market factors that affect success or failure of a product, including the supply and demand for the product, market conditions, and the behavior of competitors with similar products.
The new management has identified several possible investments for the coming year. It has asked you and your team to evaluate the possibilities and make a recommendation to the board of directors. Jorge has identified two mutually exclusive opportunities (Investment A) and two independent opportunities (Investment B) and assigned you the task of making a recommendation on the investments.
Investment A
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.
Investment B
Investment B involves two independent investment opportunities. The decisions on these two investment alternatives are also independent of Investment A. Investment B-1 involves a new packaging machine, which will eliminate the need for a local firm for packaging Vanda-Laye's products. The cost of this machine will be $24,000, and the expected revenues from this opportunity are given in the table and are considered to be of average risk. Investment B-2 is the purchase of a new computer system that will allow the company to sell its products on the Internet worldwide. The cost of this new system will be $29,000, with the expected cash flows after taxes given in the table.
Click here to download the table for Investment B.
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.
For Investment B:
Using Microsoft Excel, calculate the NPV for each alternative.
Using the decision-making criteria for the NPV, specify which alternative you would select if the two alternatives were mutually exclusive. Explain your answer.
Given that the two alternatives are independent of each other, specify which investment you would select, if not both. Explain your answer.
Using Microsoft Excel, calculate the IRR for each investment.
Using the decision-making criteria for the IRR, specify which alternative you would prefer. Explain your answer.
If funding were available, specify whether you would select both investments. Why or why not?
Calculate the profitability index (PI) for the two investments. Which project is preferred?
Determine whether there is a ranking conflict present in terms of the IRR and the NPV. Explain your answer. If a conflict does exist, explain how you would resolve the situation.
