Question

Consider a project to supply Detroit with 35,000 tons of machine screws annually for automobile production. You will need an initial $2,900,000 investment in threading equipment to get the project started; the project will last for five years. The accounting department estimates that annual fixed costs will be $495,000 and that variable costs should be $285 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the five-year project life. It also estimates a salvage value of $300,000 after dismantling costs. The marketing department estimates that the automakers will get the contract at a price of $345 per ton. The engineering department estimates you will need an initial net working capital investment of $450,000. You require a 13 percent return and face a marginal tax rate of 38 percent on this project.

*In Excel*

a. What is the estimated operating cash flow for this project?(20 points)

b. What is the NPV? Is the project acceptable?(20 points)

c. Suppose you believe that the accounting department’s initial cost and salvage value projections are accurate only to within +/-15 percent; and the engineering department’s net working capital estimate is accurate only to within +/- 5 percent. What is your worst case scenario for this project? Your best-case scenario? Do you still want to pursuit this project?(30 points)

d. Suppose you are confident with your own projections, but you are a little unsure about Detroit’s actual machine screw requirements. What is the sensitivity of the project OCF to changes in the quantity supplied? What about the sensitivity of NPV to changes in quantity supplied? Given the sensitivity number you calculated, is there some minimum level of output below which you wouldn’t want to operate? Why?(30 points)

Answer 1

(1) Depreciation each year = 2,900,000 / 5 years = 580,000

Calculation of annual cash flows:

Particulars	Amount
Contract price per unit	$                    345
Varible cost per unit	$                    285
Contribution per unit	$                      60
Total contribution	$        21,00,000
(60 * 35,000)
Less:
Fixed cost	$          4,95,000
Depreciation	$          5,80,000
Profit	$        10,25,000
Taxes 38%	$          3,89,500
Net profit after taxes	$          6,35,500
Add: Depreciation	$          5,80,000
Net cash flows	$        12,15,500

Therefore, estimated operation cash flows each year = $ 1,215,500

(2) Net Present Value:

Initial investment = 2,900,000

Working capital investment = 450,000 which will be reverted back in the terminal year

Annual cash flows at present values:

Annual cash flows * Present value annuity interest factor of 13% for 5 years

Present value annuity interest factor of r% for n years = (1/1+r)¹ + (1/1+r)² + ...... + (1/1+r)ⁿ

Present value annuity interest factor of 13% for 5 years = (1/1+0.13)¹ + (1/1+0.13)² + .... + (1/1+0.13)⁵ = 3.517

Annual cash flows * Present value annuity interest factor of 13% for 5 years = 1,215,500 * 3.517 = $ 4,274,914

Terminal cash flows:

Salvage value = 300,000

Net Salvage value after taxes = 300,000 - (300,000 * 38%) = 186,000

Working capital = 450,000

Total terminal cash inflows = 186,000 + 450,000 = 636,000

Present value of terminal cash inflow = 636,000 * Present value interest factor of 13% of 5th year

= 636,000 * (1/1+0.13)⁵

= 345,195

Net Present Value = Present value of annual cash inflows + Present value of terminal cash inflow minus (Initial Investment + Working capital investment)

N. P. V. = 4,274,914 + 345,195 - 2,900,000 - 450,000 = $ 1,270,109

The project is acceptable as the Net Present Value is positive.

(3) Worst case scenario & best case scenario

Particulars	Cash flow	Worst case	Best case
Initial cost	2,900,000	2,900,000 + 15% = 3,335,000	2,900,000 - 15% = 2,465,000
Salvage value	300,000	300,000 - 15% = 255,000	300,000 + 15% = 345,000
Working capital	450,000	450,000 +5% = 472,500	450,000 - 5% = 382,500

N P V under worst case scenario:

Initial investment = 3,335,000

Working capital investment = 472,500

Terminal cash flows:

Salvage value = 255,000

Net Salvage value after taxes = 255,000 - (255,000 * 38%) = 158,100

Working capital = 472,500

Total terminal cash inflows = 158,100 + 472,500 = 630,600

Present value of terminal cash inflow = 630,600 * Present value interest factor of 13% of 5th year

= 630,600 * (1/1+0.13)⁵

= 342,264

Net Present Value = Present value of annual cash inflows + Present value of terminal cash inflow minus (Initial Investment + Working capital investment)

N. P. V. = 4,274,914 + 342,264 - 3,335,000 - 472,500 = $ 809,678

N P V is still positive in worst case scenario hence the project is acceptable:

N P V under best case scenario:

Initial investment = 2,465,000

Working capital investment = 382,500

Terminal cash flows:

Salvage value = 345,000

Net Salvage value after taxes = 345,000 - (345,000 * 38%) = 213,900

Working capital = 382,500

Total terminal cash inflows = 213,900 + 382,500 = 596,400

Present value of terminal cash inflow = 596,400 * Present value interest factor of 13% of 5th year

= 596,400 * (1/1+0.13)⁵

= 323,702

Net Present Value = Present value of annual cash inflows + Present value of terminal cash inflow minus (Initial Investment + Working capital investment)

N. P. V. = 4,274,914 + 323,702 - 2,465,000 - 382,500 = $ 1,751,116

N P V is positive in best case scenario hence the project is acceptable: