Question

1. (13 pts.) Dave Alvin, the CFO of Blasters Powertrain Products (BPP) has requested your assistance in evaluating a capital budgeting proposal. The proposal involves the production of a new line of gearboxes for use in heavy freight applications. Research and development costs to develop this new line of gearboxes were $570,000 last year (2018). Production of the new product would require investment in (i.e., the purchase of) new machinery at a cost of $6.6 million, with a useful life of 4 years. BPP has conferred with its tax accountant and has been informed that they must depreciate the machinery under the MACRs 5-year class. (See page 4 for a MACRS depreciation schedule.) Forecasts indicate that the machinery can be sold for a market value of $270,480 at the end of the 4-year period. Management expects sales to be $7.65 million in year 1, and sales are projected to increase by 6%/year over the life of the project. Variable production costs are projected to be $5.85 million in year 1 and management expects these costs to increase by 2%/year over the life of the project. Fixed production costs for the gearboxes are expected to be $165,000 each year. If BPP produces the new line of gearboxes, BPP will need to make additional investments in Net Working Capital (NWC) to support the increased operations. In particular, NWC (entering any year) is expected to be 10% of the projected sales for that year. That is, the NWC balance at t=0 would be 10% of the projected sales for year 1, the NWC balance at t=1 would be 10% of the projected sales for t=2, and so on. The cumulative investments in NWC made as a result of this project would be recovered in the project's final year. In other words, the NWC balance will drop to $0 at t = 4. The discount rate (also called cost of capital) used to evaluate this project would be 9.06% (although this variable is not needed in this problem, given the instructions below), and the relevant tax rate is 25.00%.

Develop the incremental cash flow projections for this proposal. Your worksheet should resemble the numerous examples covered in Lesson 6, including the terms relating to “operating” cash flows, ΔNWC, and net capital spending. Of course, any given column in your worksheet should contain the total cash flow for that column. [Note: Normally, you would then use these cash flows to calculate NPV and IRR of the decision to start the new line of gearboxes or (2) do nothing. If NPV > 0 (and, equivalently, IRR > required return), then the firm will choose option 1. If NPV < 0 (and, equivalently, IRR < required return), then the firm will choose option 2. However, this assignment already contains an adequate number of other NPV and IRR calculations.] 2

Answer 1

First we will calculate the cash flow projections

Particulars	Year 1	Year 2	3	4
Sales	7650000	8109000	8595540	9111272
Variable cost	5850000	5967000	6086340	6208067
Fixed Cost	165000	165000	165000	165000
PBIDT	1635000	1977000	2344200	2738206
PAT	1226250	1482750	1758150	2053654
Depreciation	1320000	2112000	1267200	760320
Tax saved on Depreciation(25% of Above)	330000	528000	316800	190080
Change in NWC	-45900	-48654	-51573	911127
Salvage Value	0	0	0	270480
Cash Flow	1510350	1962096	2023377	3425341
Discount [email protected]%	0.9169	0.8407	0.7709	0.7068
Discounted cash Inflows	1384880	1649534	1559821	2421031

Total Present Value of Cash flows = 7015266

Intial Investment Value = 6600000

NPV of the project = $415266

Now we will Calculate the IRR of the project by using trail and error method

Year	0	1	2	3	4	NPV
Cash Flows	(6600000)	1510350	1962096	2023377	3425341
Discount Factor@10%	1	0.909	0.826	0.751	0.683
Discounted cash Inflows	(6600000)	1372908	1620691	1519556	2339508	252664
Discount Factor@15%	1	0.87	0.756	0.658	0.578
Discounted cash Inflows	(6600000)	1314005	1483345	1331382	1979847	(491422)

= 0.1+0.017

= 0.117

IRR = 11.7%