Question

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.]

Answer 1