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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.
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.
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.
