Question

NOK Plastics is considering the acquisition of a new plastic injection-molding machine to make a line of plastic fittings. The cost of the machine and dies is $125,000. Shipping and installation is another $8,000. NOK estimates it will need a $10,000 investment in net working capital initially, which will be recovered at the end of the life of the equipment. Sales of the new plastic fittings are expected to be $350,000 annually. Cost of goods sold are expected to be 50% of sales. Additional operating expenses are projected to be $115,000 per year over the machine’s expected 5-year useful life. The machine will depreciated using a 5-year MACRS class life. The equipment will be sold at the end of its useful life (5 years) for $35,000. The tax rate is 25% and the relevant discount rate is 15%. Calculate the net present value (NPV), internal rate of return (IRR), payback period (PB), and profitability index (PI) and state whether the project should be accepted.

Answer 1

	The cash flows are worked out as below:	0	1	2	3	4	5
	Sales		$        3,50,000	$     3,50,000	$    3,50,000	$     3,50,000	$ 3,50,000
	-COGS [50% of sales]		$        1,75,000	$     1,75,000	$    1,75,000	$     1,75,000	$ 1,75,000
	-Additional operating expenses		$        1,15,000	$     1,15,000	$    1,15,000	$     1,15,000	$ 1,15,000
	-Depreciation [MACRS--on $133,000]		$            26,600	$         42,560	$        25,536	$         15,322	$     15,322	$          7,661	$    1,33,000
	=Incremental EBIT		$            33,400	$         17,440	$        34,464	$         44,678	$     44,678
	-Tax at 25%		$              8,350	$           4,360	$          8,616	$         11,170	$     11,170
	=Incremental NOPAT		$            41,750	$         21,800	$        43,080	$         55,848	$     55,848
	+Depreciation		$            26,600	$         42,560	$        25,536	$         15,322	$     15,322
	=Incremental OCF		$            68,350	$         64,360	$        68,616	$         71,170	$     71,170
	-Capital expenditure	$     1,33,000
	-Increase in NWC	$         10,000
	+Recovery of NWC						$     10,000
	+After tax salvage value = 35000-(35000-7661)*25% =						$     28,165
	=Annual project cash flows	$   -1,43,000	$            68,350	$         64,360	$        68,616	$         71,170	$ 1,09,335	$    2,38,830
1]	Payback period:
	Cumulative cash flows	$   -1,43,000	$          -74,650	$       -10,290	$        58,326	$     1,29,496	$ 2,38,830
	Payback period = 2+10290/68616 =	2.15	Years
2]	NPV:
	PVIF at 15%	1	0.86957	0.75614	0.65752	0.57175	0.49718
	PV at 15%	$   -1,43,000	$            59,435	$         48,665	$        45,116	$         40,691	$     54,359
	NPV	$     1,05,267
3]	PI:
	PI = PV of cash inflows/Initial investment = 248267/143000 =	1.74
4]	IRR is that discount rate for which NPV = 0.
	It has to be found out by trial and error.
	Discounting with 40%:
	PVIF at 40%	1	0.71429	0.51020	0.36443	0.26031	0.18593
	PV at 40%	$   -1,43,000	$            48,821	$         32,837	$        25,006	$         18,526	$     20,329	$          2,519
	Discounting with 41%:
	PVIF at41%	1	0.70922	0.50299	0.35673	0.25300	0.17943
	PV at 41%	$   -1,43,000	$            48,475	$         32,373	$        24,478	$         18,006	$     19,618	$               -50
	IRR = 40%+1%*2519/(2519+50) =	40.98%

5] The project should be accepted as the NPV is positive.