Question

Guthrie 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 $132,000. The tax rate is 22 percent and you Year Market Value ($ millions) 1 $ 14.70 2 11.70 3 9.20 4 1.95 4 | P a g e 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. Show step by step solution

Answer 1

CF0=-Cost of equipment-working capital
CF1, CF2, CF3, CF4, CF5=((number of cartons*(price per carton-variable cost per carton)-fixed costs per year-depreciation)*(1-tax rate)+depreciation)
Additional cash flow in year 5=Salvage value*(1-tax rate)+working capital
Depreciation=Initial cost of equipment/5
NPV=CF0+CF1/(1+r)+CF2/(1+r)^2+CF3/(1+r)^3+CF4/(1+r)^4+CF5/(1+r)^5+Additional cash flow in year 5/(1+r)^5

a. Calculate the project NPV. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
NPV=-1820000+152000*(1-22%)/1.12^5-132000+132000/1.12^5+((142000*(16.20-9.60)-267000-1820000/5)*(1-22%)+1820000/5)/12%*(1-1/1.12^5)=363263.33969

b. What is the minimum number of cartons per year that can be supplied and still break even?
At breakeven, NPV=0
-1820000+152000*(1-22%)/1.12^5-132000+132000/1.12^5+((Q*(16.20-9.60)-267000-1820000/5)*(1-22%)+1820000/5)/12%*(1-1/1.12^5)=0
=>Q=122424.866805

c. What is the highest fixed costs that could be incurred and still break even?
-1820000+152000*(1-22%)/1.12^5-132000+132000/1.12^5+((142000*(16.20-9.60)-F-1820000/5)*(1-22%)+1820000/5)/12%*(1-1/1.12^5)=0
=>F=396195.879085