# Atlantic Aquaculture

Atlantic Aquaculture, Inc. Capital Budgeting with Staged Entry
Question 1

A. Even though Atlantic Aquaculture already bought the land needed for 300,000 USD, its value today is 900,000 USD. We can, therefore, conclude the 900,000 USD is an opportunity cost as the land can be sold at this value.
B. In this case, it is best for the company to use the option of land acquisition. By calculating the NPV the option is worth \$-852,093. 66. Buying the land without the option would bring the company back to \$-900,000. 00. We used a discount rate of 6%, as this is linked with the appreciation of the land annually.

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The calculation of the NPV can be found in Appendix A.
Question 2

A. The R&D cash flows are \$48,000 annually for the years 1998, 1999, and 2000. In 1996 we are able to shield taxes with appreciation. At a tax rate of 40%, this results in a tax shield worth \$144,000.
B. From the case is known that the salvage value will only be taxed when the buildings are actually sold, as long as the asset’s value is half of the book value the sale will go through with. Take note that a 40% tax rate is used to calculate the tax shield.
C. The cash flows are shown in Appendix B.

Question 3
As can be seen in Appendix C the large project, while taking into account a reach of 9% and the expectation that there will be high demand and high growth opportunities for the firm’s products; the Net Present Value of the firm will be \$17,140,000. 00. An Internal Rate of Return will be realized of 25. 83%. Furthermore, the MIRR is calculated as 21. 54% and the payback period of the project is 7. 05 years. Taking all other factors the same, when the firm is building a small facility, the NPV would be \$11,723,000. 00, the IRR 23. 39%, the MIRR 18. 5% and the period in which the costs will be paid back 7. 18 years.
Question 4

A. In the Appendix, the decision trees are shown and the following elements deserve attention. The nodes start with having high/low demand being 10,000 or 5,000 respectively. There is a 75% chance demand will be high, while a 25% probability that demand will be low. The following pair of nodes, given differing probabilities (as can be seen in the Appendix), leads to the yearly cash flows. In de first years it is obvious that the cash flows are negative as the start-up investments have some weight on the cash flows. From 1998 onwards, as sales start to increase and costs decrease the flows of cash are positive. In row three and four the cash flows, given a low demand of 5,000 units sold with their corresponding probabilities. It is clear that the costs definitely outweigh the revenues for the first few years, more than in the ‘best-case’ term in rows one and two. Interesting to see that in the final row, there is only a positive cash flow recorded in the final year of the project. In this case, we can explain the NPV values of all probabilities very straightforward. With the given information the cash flows will be negative in case the demand will be low. However, we need to make a remark on this simplification of the results. By calculating the expected NPV (which is the sum of the probabilities of each high/low demand occurring times their corresponding NPVs). This gives, in the end, a positive NPV so investors can assume this project will be successful.
B. The abandonment lines basically represent a situation in which the project is stopped for continuation. What is interesting to notice is that the NPV of the project that continued is lower than the projects where the project was dismantled. Note too that this only applies to the situation where a low demand is expected. The NPV in those cases when the projects are abandoned is equal to the salvage value of the equipment and buildings.
C. As the flexibility of the project gets smaller, the NPV will get smaller and due to higher volatility, the standard deviation will increase.

Question 5

A. Due to the fact that there is an extra decision node the tree looks bigger. This extra decision is namely the decision to expand the plant or leave it in its current state.
B. As this is not possible to trace back from the information we can retrieve from the case. As the decision to expand or not to expand lies at the responsibility of the managers at the firm, probabilities are not able to be calculated here. However, the manager will always choose the option with the higher NPV.

Question 6
As can be seen from the given data, in terms of expected Net Present Values, the large plant seems to have a big advantage over the smaller project with NPVs of \$9,028,000 and \$8,062,000 respectively. On the risk side, however, the standard deviation of the small project is almost half of the large project. It is important to mention at this point that building a new plant appears riskier. In accordance with that, one should use a risk adjustment incorporated in the cost of capital which should be higher than the discount rate of the small project.
Question 7
As the risk coefficient of the large project is 1. 15 and it is known that most projects of Atlantic lie between 0. 5 and 0. 7 the large project is considered to be a lot more risky compared to the small project which has a risk coefficient of just 0. 65.
Question 8
The reassessment of possibilities has the consequence that standard deviation, covariance and NPV change as well.

Lrge Plant
D=60% G=50%
D=75% G= 80%
D=90% G=90%

Small Plant
D=60% G= 50%
D=75% G=80%
D=90% G=90%

E(NPV)
3327,95
9028,2
13459,36

E(NPV)
6314,35
8008,17
10049,99

Std. Dev
9827,17
10341,43
7869,12

Std. Dev
4871,06
5375,57
4017,85

Coeff. Of Var.
2,95
1,15
0,58

Coeff. Of Var.
0,77
0,67
0,4

The results show that an increase in demand and growth probabilities for both of the plants (small and large) results in a higher expected NPV, lower standard deviation, and lower correlation, leading to a higher risk-return payoff. Decreasing initial demand to 60% and high growth possibilities to 50% simultaneously, leads to a decrease in expected NPV while increasing standard deviation and the covariance leading to a lower risk-return payoff. Furthermore, one can observe that in absolute and in relative terms, the impact on the small plant of increasing/decreasing initial demand and growth opportunities does not have as great influence as on the large plant.
Question 9
A sensitivity analysis can help to underline the most important factors affecting the success of a firm or a project. In this case we have articulated success in terms of NPV and have used input factors such as variable costs, units sold, sales price, and WACC). With respect to the two different plants, one can observe that NPV is relatively more sensitive to the mentioned factors in the case of the small plant. Furthermore, regarding the line of sales prices, one can see that this is by far the line with the highest positive slope (coefficient), while fixed costs have the shallowest slope. The interpretation therefore is that sales prices have the biggest impact on expected NPV.
Furthermore, it is worth mentioning that the slope (and the impact) of WACC is quite high (negative) for the large plant. Since the variable costs for the large plant are lower at a rate of 60% compared to 65% of the small plant, one can observe that the sensitivity of the small plant’s NPV is also relatively high. Question 10 In the Case of scenario analysis it is important to mention that in contrast to the analysis mentioned above, probabilities are appointed to each of the different scenarios. Atlantic Aquaculture Inc. uses best and worst-case scenarios (high initial demand/ low initial demand). In addition to that, a scenario analysis appoints a base case as well. This should be done utilizing a probability of 50% for the base scenario and probabilities for the best and worst should lie at 25% respectively. Independent factors should again be inputs such as variable costs, units sold, sales price, and the weighted average of the cost of capital. These inputs should be appointed to a realistic assessment of the range they could approach. The dependent variable logically should be the net present values of the different scenarios. In terms of the ranges of independent variables it should be noted, that these could be obtained by examining historical data of the company in addition to an examination and assessment of company and market environment.
Question 11
A Monte Carlo simulation typically provides one with an overwhelmingly high amount of simulations, whereas a change of all the variables occurs on a random basis. However, only the average of these is of importance. The input incorporates the correlations of all the variables included. The output is then expressed in the form of samples of NPVs. It is perceived as a more sophisticated way of conducting a scenario analysis. However, it is also perceived as very delicate in terms of the conduction itself.
Question 12
Indeed the abandonment opportunity represents a real put option. This is due to the fact that the company can abandon the project and receive a terminal value. However, this is only reasonable if Atlantic Aquaculture Inc. sells the plant when the salvage value is higher than the value of the discounted future cash flows otherwise received from the project. In this case, the real put option would be in the money and vice versa. Regarding the decision tree, with respect to the low demand and low growth opportunity for plan Lone can see that the decision of abandonment or not changes the NPV of the project from \$-9. 316. 000 to \$-6. 711. 000. Regarding the scenario of low initial demand and high growth opportunities the choice to abandon changes the NPV from \$-6. 940. 000 to \$-6. 439. 000. In both cases it appears to be feasible to abandon the project, thus the value of the put option is positive. Plan S on the other side represents a call option since one can decide to buy the facilities or not.
Furthermore, the put option for the large plant can be calculated as follows: This leads us to a value of \$546. 050, which indeed is positive. Question 13 In general, it can be said that both plans have a positive expected NPV overall. However, the smaller plant is the favorable option, since it provides Atlantic Aquaculture with the best risk-return payoff. Furthermore, if opting for the large plant it is important to mention that the value of the put- option is positive, so in the worst case Atlantic Aquaculture should opt-out when facing low initial demand and either low or high growth potential.

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