Question

1. You are considering a project that will supply an automobile production facility with 35,000 tonnes of machine screws annually for five years. To get the project started, you will need an initial $1,500,000 investment in threading equipment. The project will last for five years. The accounting department estimates that annual fixed costs will be $300,000 and that variable costs should be $200 per tonne. The CCA rate for treading equipment is 20%. Accounting estimates a salvage value of $500,000 after costs of dismantling. The marketing department estimates that the auto makers will accept the contract at a selling price of $230 per tonne. The engineering department estimates you will need an initial net working capital investment of $450,000. You require a 13% return and face a marginal tax rate of 38% on this project.                (14 marks total)

a.   What is the NPV for this project? Should you pursue this project?        

b. Suppose you believe that the accounting department’s initial cost and salvage projections are accurate only to within ±15%; the marketing department’s price estimate is accurate only to within ±10%; and the engineering department’s net working capital estimate is accurate only to within ±5%. What is your worst-case scenario for this project? Your best-case scenario?                              

Answer 1

a]

Cumulative depreciation upto year 5 = $1,008,480

book value of equipment at end of year 5 = $1,500,000 - $1,008,480 = $491,520

salvage value = $500,000

profit on sale of equipment = $500,000 - $491,520 = $8,480

tax on profit on sale of equipment = $8,480 * 38% = $3,222

net salvage value after tax = $500,000 - $3,222 = $496,778

NPV of this project is $668,583. This project should be accepted as it has a positive NPV

b]

For the worst case scenario, we increase initial cost by 15%, reduce salvage value by 15%, reduce price by 10%, and increase net working capital by 5%

Cumulative depreciation upto year 5 = $1,159,752

book value of equipment at end of year 5 = $1,725,000 - $1,159,752 = $565,248

salvage value = $425,000

loss on sale of equipment = $425,000 - $565,248 = $140,248

tax advantage on loss on sale of equipment = $140,248 * 38% = $53,294

net salvage value after tax = $425,000 + $53,294 = $478,294

NPV of worst-case scenario is -$1,280,326

For the best case scenario, we decrease initial cost by 15%, increase salvage value by 15%, increase price by 10%, and decrease net working capital by 5%

Cumulative depreciation upto year 5 = $857,208

book value of equipment at end of year 5 = $1,275,000 - $857,208 = $417,792

salvage value = $575,000

profit on sale of equipment = $575,000 - $417,792 = $7,208

tax on profit on sale of equipment = $7,208 * 38% = $2,739

net salvage value after tax = $575,000 - $2,739 = $572,261

NPV of best-case scenario is $2,648,429