Case Study-AW705

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As the newly appointed Director of Finance at the GeKay Company, Chris Doyle is about to analyze a proposal that the firm has been considering for developing guano as a garden fertilizer – the “guano project”. Doyle is considering the forecasts his assistant recently provided him.

The company had already spent $100,000 on a feasibility study of this project which raised some questions about its potential profitability. So Doyle felt the pressure to be sure the analysis was correct, knowing that his boss, George Kanatas, the great grand-son of the founder, Elmer Fudd was unforgiving of mistakes!

Doyle once again reviewed the numbers. The Guano Project would have a life of 5 years. To undertake the project, the firm would need the use of some specialized equipment that it would purchase now (t=0) for $800,000, have a useable life of 8 years; the expectation is that the equipment would be sold at project end for half its initial cost. The project was expected to generate $550,000 in revenue the first year and increase by 10% per year thereafter; annual (direct) labor costs were estimated at about 20% of revenue while annual materials costs are expected to be 35% of revenue and annual SG&A costs at $150,000.

In addition, undertaking the project would require an investment of $250,000 in additional new equipment at the end of year 2 of the project. This equipment would have a useable life of 5 years and is expected to be sold at the end of the project for its book value.

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As for working capital — it was estimated that $125,000 would be needed at the initiation of the project and then subsequently, at the end of each year, working capital was expected to be 10% of that year’s revenue, except at the project end when it was expected that the working capital would be fully recovered. All depreciation would be straight line (Aside: note that straight line is for simplicity here and would never be chosen in reality because of the better tax benefits of the faster depreciation allowed by the IRS). The assistant had also estimated that GeKay would be in the 30% tax bracket over the next 5 years, and that it requires a return of 15% for projects such as the one here.

Doyle was relatively confident of his assistant’s numbers, except for the revenue and direct labor costs. He worried that both numbers were overly optimistic; perhaps 5% revenue growth and labor costs at 25% of revenue instead of 20% might be more realistic. But he wondered if he was agonizing over nothing! Then he thought again of Kanatas and returned to worrying about the forecasts.

A. Using the assistant’s forecasts, determine
● Each year’s investment free cash flows
● Each year’s operating free cash flows
● Project’s NPV and IRR
● Project’s Profitability Index
● Project’s Payback
● Project’s Discounted Payback
B. Assuming the assistant’s forecasts other than those for revenue growth and direct labor are reliable, use NPV analysis to advise Doyle about the revenue growth and labor cost projections.
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