Question

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 investment of $1,500,000 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 threading 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 $250 per tonne. The engineering department estimates you will need an initial net working capital investment of $450,000. You require a 15% return and face a marginal tax rate of 38% on this project.

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) The Free Cashflow calculation is as given below

Year	0	1	2	3	4	5
Production Qty		35000	35000	35000	35000	35000
Selling Price		250	250	250	250	250
Variable Cost		200	200	200	200	200
Revenue		8750000	8750000	8750000	8750000	8750000
Total Variable cost		7000000	7000000	7000000	7000000	7000000
Total Fixed Cost		300000	300000	300000	300000	300000
Depreciation		300000	240000	192000	153600	122880
Profit Before Tax		1150000	1210000	1258000	1296400	1327120
Less Tax		437000	459800	478040	492632	504305.6
PAT		713000	750200	779960	803768	822814.4
Add: Depreciation		300000	240000	192000	153600	122880
Cost	1500000
After tax Salvage value						496777.6
NWC	450000					450000
Free Cashflows	-1950000	1013000	990200	971960	957368	1892472

NPV = -1950000 + 1013000/1.15 +990200/1.15^2+971960/1.15^3+957368/1.15^4+1892472/1.15^5

=$1806953.81

As the NPV is positive , the project should be pursued

b) The worst case scenario will ocur when Initial cost is on higher side and salvage value is on lower side, price is on the lower side and NWC is on the higher side

So , in the worst case scenario

Initial Cost = $1500000*1.15 = $1725000

Salvage value = $500000 * 0.85 = $425000

Price per unit = $250 *0.9 = $225

NWC = $450000*1.05 =$472500

Similarly, the best case scenario will ocur when Initial cost is on lower side and salvage value is on higher side, price is on the higher side and NWC is on the lower side

So , in the Best case scenario

Initial Cost = $1500000*0.85 = $1275000

Salvage value = $500000 * 0.1.15 = $575000

Price per unit = $250 *1.1 = $2725

NWC = $450000*0.95 =$427500

Other variables remaining the same