Small construction company analysis

Johann is the owner of a small construction company. He is thinking about purchasing some construction equipment; however, he knows that the economy will have a major impact on his future cash flows. He is not quite sure what to do with the scenario data that his financial officer gave him, and he is looking for your advice. Scenario Analysis Worst Case Most Likely Best Case 30% Probability 50% Probability 20% Probability Cost of Investment (Year 0) 308,000 308,000 308,000 Year 1 Net Cash Flow 62,500 84,500 92,500 Year 2 Net Cash Flow 70,800 95,020 100,450 Year 3 Net Cash Flow 84,600 102,500 114,800 Year 4 Net Cash Flow 68,000 94,800 102,500 Year 5 Net Cash Flow 54,500 76,000 86,400 Salvage value (end of year 5) 12,000 26,000 38,000 You explain to him that the expected return of the project is the sum of the weighted expected returns from each scenario. • Question 1 – Does the project make sense if the cost of capital is 12%? Explain. • Question 2 – Does the project make sense if Johann demands an internal rate of return of 15%? Explain. • Question 3 – Johann is worried about meeting cash flows in the future and requires a 3.5 year payback. Will the project meet his goal? Should payback be a consideration? Explain. • Question 4 – The devil is always in the details – especially the return assumptions. Please read “Risk Analysis in Capital Investment” by David Hertz. Then discuss a] any actual situation where you have been involved in the process of estimating returns for a desired project and b] whether the actual outcome was anywhere close to expectations (or whether anyone ever went back and checked the estimates). What suggestions do you have that might improve the projected estimates?