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Project Risk

HMG is considering the manufacture of a new chemical compound that is used to make high-pressure plastic containers. An investment of $4 million in plant and equipment is required. The firm estimates the investment will have a five-year life, using straight-line depreciation toward a zero salvage value. However, the investment has an anticipated salvage value equal to 10% of its original cost.
The projected numbers of pounds of the chemical compound that HMG expects to sell over the five-year life of the project are as follows (in millions): 1, 1.5, 3, 3.5 and 2.
To operate the new plant, HMG estimates that it will incur additional fixed cash operating expenses of $1 million per year and variable operating expenses equal to 45% of revenues. Furthermore, HMG estimates that it will need to invest 10% of the anticipated increase in revenues each year in net working capital. The price per pound for the new compound is expecting to be $2 in years 1 and 2, then $2.50 per pound in years 3 through 5. HMG's tax rate is 38% and it requires a 15% rate of return on its new product investments.
Exhibit P2-8.1 contains projected cash flows for the entire life of the proposed investment. Note that investment cash flow is derived from the additional revenues and costs associated with the proposed investment.
Exhibit P2-8.1 is attached.

Answer the following questions:

a. What are the key sources of risk that you see in this project?
b. Use the "Goal Seek" function within Excel to find the breakeven values (i.e., values that force the project NPV to equal zero) for each of the following variables: the initial CAPEX , the working capital percentage of revenue growth, variable cost % of sales, and sales volume. (Hint: scale the sales volume for all five years up and down by the same percenatge.)
c. Which of the variables analyzed in part b do you think is the greatest source of concern? What if, anything, could you do to reduce the risk of the project?
d. Should you always seek to reduce project risk?


Solution Summary

The solution explains the key sources of risk for the project and how to reduce risk