Question

Chandler Enterprises needs someone to supply it with 142,000 cartons of machine screws per year to support its manufacturing needs over the next five years. It will cost $1,820,000 to install the equipment necessary to start production; you’ll depreciate this cost straight-line to zero over the project’s life. You estimate that in five years this equipment can be salvaged for $152,000. Your fixed production costs will be $267,000 per year, and your variable production costs should be $9.60 per carton. You also need an initial investment in net working capital of $132,000. The tax rate is 22 percent and you require a return of 12 percent on your investment. Assume that the price per carton is $16.20.

a. Calculate the project NPV.

b. What is the minimum number of cartons per year that can be supplied and still guarantee a zero NPV? Verify that the quantity you calculated is enough to at least have a zero NPV.

c. What is the highest fixed costs that could be incurred and still guarantee a zero NPV? Verify that the fixed costs you calculated are enough to at least have a zero NPV.

Answer 1

		Calculation of Initial cash flow:
		Cost of equipment	$1,820,000
		Net working capital	$132,000
	I	Total	$1,952,000
	a	Annual Depreciation	$364,000	(1820000/5)
	b	Tax Rate	22%
	c=a*b	Annual Depreciation tax shield	$80,080
	d	After tax salvage value at end of 5 years	$118,560	(152000*(1-0.22)
	e	Contribution per carton(16.2-9.6)	$6.60
	f=e*142000	Total Contribution per year	$937,200
	g	Annual Fixed Cost	$267,000
	h=f-g	Annual operating profit(Before tax)excluding depreciation	$670,200
	i=h*(1-0.22)	After tax operating profit excluding depreciation	$522,756
	j=d+132000	Terminal Cash Flow=Salvage Value+Release of working Capital	$250,560
		Present Value of cash flow =(Cash Flow)/((1+i)^N)
		i=discount rate =12%=0.12, N=Year of cash flow
	N	Year	0	1	2	3	4	5
	I	Initial Cash Flow	($1,952,000)
	i	After tax operating profit		$522,756	$522,756	$522,756	$522,756	$522,756
	c	Annual Depreciation tax shield		$80,080	$80,080	$80,080	$80,080	$80,080
	j	Terminal Cash Flow at end of 5 years						$250,560
	CF=I+i+c+j	Net Cash Flow	($1,952,000)	$602,836	$602,836	$602,836	$602,836	$853,396	SUM
	PV=CF/(1.12^N)	Present Value of Cash Flow	($1,952,000)	$538,246	$480,577	$429,087	$383,113	$484,240	$363,263
a	NPV=Sum of PV	NPV	$363,263
	b	For NPV =0
		After tax Operating Profit=	$421,983
	N	Year	0	1	2	3	4	5
	I	Initial Cash Flow	($1,952,000)
	i	After tax operating profit		$421,983	$421,983	$421,983	$421,983	$421,983
	c	Annual Depreciation tax shield		$80,080	$80,080	$80,080	$80,080	$80,080
	d	After tax salvage value at end of 5 years						$250,560
	CF=I+i+c+d	Net Cash Flow	($1,952,000)	$502,063	$502,063	$502,063	$502,063	$752,623	SUM
	PV=CF/(1.12^N)	Present Value of Cash Flow	($1,952,000)	$448,271	$400,242	$357,359	$319,070	$427,059	($0)
		NPV	($0)
		Before tax operating Profit =421983/(1-0.22)	$479,526
		Annual Contribution Required=479526+267000	$746,526
		Number of Cartons =746526/6.6	113,110
	c	Highest fixed cost to guarrantee Zero NPV
		Before tax operating Profit =421983/(1-0.22)	$479,526
		Annual Contribution	$937,200
		Highest fixed cost to guarantee Zero NPV	$457,674	(937200-479526)