You are an economist for the Vanda-Laye Corporation, which produces and distribu
ID: 2653937 • Letter: Y
Question
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)
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)
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.
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
Debt Equity Total Waitage 30.00% 70.00% 100.00% Cost of capital 7.00% 15.57% 22.57% Weighted cost 2.10% 10.90% 13.00% Weighted average cost of capital = 13% Demand Outdoor Smooker Probability Year 1 Year 2 Year 3 Year 4 Year 5 Total High 0.2 800000 900000 1000000 1100000 1500000 5300000 Moderate 0.6 500000 700000 800000 960000 1240000 4200000 Low 0.2 200000 350000 500000 600000 750000 2400000 Expected Demand 500000 670000 780000 916000 1194000 4060000 Solvage Value 790000 790000 Cash inflows 500000 670000 780000 916000 1984000 4850000 PV factor at 13% 0.88496 0.783147 0.69305 0.61332 0.54276 Present Value 442478 524708.3 540579 561800 1076836 3146401 Demand Outdoor Grill Probability Year 1 Year 2 Year 3 Year 4 Year 5 Total High 0.2 600000 750000 850000 975000 5160000 8335000 Moderate 0.6 450000 500000 700000 825000 4980000 7455000 Low 0.2 150000 220000 370000 500000 4750000 5990000 Expected Demand 420000 494000 664000 790000 4970000 7338000 Solvage Value 4000000 4000000 Cash inflows 420000 494000 664000 790000 8970000 11338000 PV factor at 13% 0.88496 0.783147 0.69305 0.61332 0.54276 Present Value 371681 386874.5 460185 484522 4868557 6571820 Net present Value Outdoor Smooker (3,146,401-7,000,000) -3853599 Outdoor Grill (6,571,820-3,987,000) 2584820 Bothe Ourdoor smooker and outdoor grill are mutually exclussive and we will opt Outdoor grill it is because outdoor grill has +ve net present value. Even if Money is available Outdoor smooker should not be taken because its net present value is negative. Investment B Packing Machine Computer sustem PV factor Present Value Year Cashflows Cashflows at 13% Packing Machine Computer systed 0 -24000 -29000 1.00000 -24000 -29000 1 8400 9100 0.88496 7433.63 8053.1 2 4800 8800 0.78315 3759.1 6891.69 3 7800 8300 0.69305 5405.79 5752.32 4 6200 8000 0.61332 3802.58 4906.55 5 5500 5100 0.54276 2985.18 2768.08 6 4600 4000 0.48032 2209.47 1921.27 7 3000 3500 0.42506 1275.18 1487.71 Total 2870.93 2780.72 PI 0.11962 -0.0959 in Investment B. both alternative have same Net present value. So choice is indifferent to the management. However PI of Packing machine is higher as its initial investment cost is lower than the Computer susted. Hence Packing machine should be selected.
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