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.             (14 marks total)                                                                         

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

Answer :

(a) Calculation of NPV of the Project :

Production facility = 35,000 tonnes

Initial investment =  $1,500,000

Life of project = 5 Years

CCA rate for threading equipment = 20%

Estimated that annual fixed costs = $300,000

Variable costs = $200 per tonne

Selling price = $250 per tonne

Required return =  15%

Marginal tax rate = 38%

Salvage value = $500,000

Present Value Factor @15% for 5 years = 0.4972

Present Value of Salvage value = $500,000 x 0.4972 = $248,600

Initial net working capital investment = $450,000

Present Value of net working capital investment for 5 years = $450,000 x 0.4972 = $223,740

Particulars	Amount	Calculations
Sales	8,750,000	250 x 35,000
Less : Variable Costs	7,000,000	200 x 35,000
Contribution	1,750,000
Less: Fixed Cost	300,000
Profit before Depreciation and Tax	1,450,000
Less: Depreciation	300,000	1,500,000 x 20%
Profit Before Tax	1,150,000
Less: Tax@38%	437,000	1,150,000 x 38%
Profit After Tax	713,000
Add: Depreciation	300,000
Cash Flow From Operations	1,013,000

Cash Flow From Operations = $1,013,000

Present Value Annuity Factor @15% for 5 Years = 3.3522

Present Value of Cash Flow From Operations = $1,013,000 x 3.3522 = $3,395,778.6

Net Present Value =

= Present Value of Cash Flow From Operations - Initial investment + Present Value of Salvage value - Initial net working capital investment + Present Value of net working capital investment for 5 years

= $3,395,778.6 - 1,500,000 + 248,600 - 450,000 + 223,740

= $1,918,118.6

Net Present Value = $1,918,118.6

Because the Net Present Value is positive , Yes we Should pursue this project.

(b)

In Worst Case Scenario Initial Investment is increased by 15% and salvage value decreased by 15% , Selling Price reduced by 10% and Working capital Requirement increased by 5%.

In Best Case Scenario Initial Investment is decreased by 15% and salvage value Increased by 15% , Selling Price Increased by 10% and Working capital Requirement decreased by 5%.