Question

Letang Industrial Systems Company (LISC) is trying to decide between two different conveyor belt systems. System A costs $300,000, has a four-year life, and requires $101,000 in pretax annual operating costs. System B costs $380,000, has a six-year life, and requires $95,000 in pretax annual operating costs. Both systems are to be depreciated straight-line to zero over their lives and will have zero salvage value. Whichever project is chosen, it will not be replaced when it wears out. The tax rate is 22 percent and the discount rate is 10 percent.

Calculate the NPV for both conveyor belt systems. To solve the bid price problem presented in the text, we set the project NPV equal to zero and found the required price using the definition of OCF. Thus the bid price represents a financial break-even level for the project. This type of analysis can be extended to many other types of problems.       Martin Enterprises needs someone to supply it with 137,000 cartons of machine screws per year to support its manufacturing needs over the next five years, and you’ve decided to bid on the contract. It will cost you $970,000 to install the equipment necessary to start production; you’ll depreciate this cost straight-line to zero over the project’s life. You estimate that, in five years, this equipment can be salvaged for $121,000. Your fixed production costs will be $545,000 per year, and your variable production costs should be $18.55 per carton. You also need an initial investment in net working capital of $114,000. Assume your tax rate is 22 percent and you require a return of 12 percent on your investment.    a. Assuming that the price per carton is $28.40, what is the NPV of this project? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) b. Assuming that the price per carton is $28.40, find the quantity of cartons per year you can supply and still break even. (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) c. Assuming that the price per carton is $28.40, find the highest level of fixed costs you could afford each year and still break even.

Answer 1

Martin	0	1	2	3	4	5
Investment	-970,000
Salvage						121,000
NWC	-114,000					114,000
Sales		3,890,800	3,890,800	3,890,800	3,890,800	3,890,800
VC		-2,541,350	-2,541,350	-2,541,350	-2,541,350	-2,541,350
FC		-545,000	-545,000	-545,000	-545,000	-545,000
Depreciation		-194,000	-194,000	-194,000	-194,000	-194,000
EBT		610,450	610,450	610,450	610,450	610,450
Tax (22%)		-134,299	-134,299	-134,299	-134,299	-134,299
Profits		476,151	476,151	476,151	476,151	476,151
Cash Flows	-1,084,000	670,151	670,151	670,151	670,151	878,531
NPV	$ 1,449,984.78

Cash Flows = Investment + NWC + Salvage x (1 - tax) + Profits + Depreciation

NPV can be calculated using the same function in excel with 12% discount rate.

b) Break even quantity can be calculated using trial and error method such that NPV = 0

We get when quantity = 84,646, NPV = 0

c) Similarly, we need to find FC such that NPV = 0

At FC = $1,060,692, we get break even.