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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 P2-5.1 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.
a. Does this project create shareholder value?
b. If so, how much?
c. Should HMG undertake the investment?
d.What if the esitmate of the variable costs were to rise to 55%?
e. Would this affect your decision?
The solution explains some questions relating to project valuation
Understanding of the fundamentals of valuation
Section 1, Questions 1 - 6 are designed to test understanding of the fundamentals of valuation and how to estimate the value of a project, division or firm over a forecast period and how to estimate the residual value.
Section 2, Questions 1-16 are designed to test understanding of the growing perpetuity model.
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