Hypothetical company background
You are a financial analyst working in the finance department of Healthy Crops Limited. Healthy Crops is a publicly listed company that specializes in the production of organic fertilizers. The mass production of Healthy Crops relies heavily on the use of ingredients and machinery. The company has 4,390,000 shares outstanding trading on the stock exchange, and it is currently trading at $1.28 per share.

Healthy Crops Limited is an organic fertilizer manufacturer with a large customer base due to its high-quality safe products. Currently, Healthy Crops is in negotiation with a large farm supplies chain, Growmore Limited, to supply its Fast-Grow fertilizer on a private label for Growmore. Under the terms, Healthy Crops is expected to supply multiple grades of Fast-Grow fertilizers to Growmore every year for the next seven years. However, some managers and employees of Healthy Crops are not happy with this negotiation as they are anticipating that the overall production quality of the company will wane by producing fertilizers for Growmore using chemicals with detrimental side effects and it will damage the reputation of Healthy Crops. If Healthy Crops proceeds with the supply of Fast-Grow, the company needs to purchase machinery to cope with the increase in production. New machinery is expected to cost $7,600,000, with an additional $650,000 in transportation and installation costs. The machinery is expected to have a working life of 8 years. The company’s accounting policy is to depreciate using the straight-line approach of 11% per year. It is expected that this new machinery can be sold for $1,150,000 at the end of the project life. If Healthy Crops is to proceed with the supply of Fast-Grow chemical fertilizers to Growmore, it is expected that the yearly operating revenues will increase by $9,000,000 in year one. From year two onwards, it is expected that the increase in yearly operating revenues will grow at a rate of 6% per annum. Total variable costs associated with the increased production would be 55% of the increase in yearly operating revenues. The fixed costs associated with the increased production are expected to be $1,350,000 per year. Furthermore, there would be an initial increase in net working capital of $840,000.

From year one to year six, net working capital is expected to increase by $37,500 per year. All the net working capital can be recovered at the end of the project’s life. The sales manager predicts that the existing organic fertilizer sales revenue of Healthy Crops will decrease by $950,000 per annum if Healthy Crops proceeds with the supply of chemical fertilizers to Growmore as some marginal or one-off customers will switch from Healthy Crops quality brand to economy brand of Growmore. Consequentially, decreasing sales will decrease production and the existing relevant operating costs would decrease by $312,500 per annum. Given that this project’s risk level is not significantly different, you believe that it is appropriate to use the existing WACC of 16.50%. The company’s capital structure has remained fairly stable, with a debt-to-equity ratio of 0.65. The company has no plan to
adjust its capital structure in the future. The company tax rate is 30%. Furthermore, the CEO is concerned about the uncertainties in relation to some of the cash flows and suggested conducting a sensitivity analysis as follows:
1. Allow for a 30% probability that incremental revenues associated with the supply of private-label fertilizer would be 25% lower than expected starting from year four.
2. Allow for a 20% probability that incremental revenues associated with the supply of private-label fertilizer would be 25% higher than expected starting from year four.