Question

Consider a project to supply Detroit with 25,000 tons of machine screws annually for automobile production. You will need an initial $2,200,000 investment in threading equipment to get the project started; the project will last for 5 years. The accounting department estimates that annual fixed costs will be $700,000 and that variable costs should be $380 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the 5-year project life. It also estimates a salvage value of $300,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $480 per ton. The engineering department estimates you will need an initial net working capital investment of $220,000. You require a return of 12 percent and face a marginal tax rate of 22 percent on this project.

  

a-1	What is the estimated OCF for this project? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

a-2	What is the estimated NPV for this project? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

b.

Suppose you believe that the accounting department’s initial cost and salvage value projections are accurate only to within ±15 percent; the marketing department’s price estimate is accurate only to within ±10 percent; and the engineering department’s net working capital estimate is accurate only to within ±5 percent. What is the worst-case NPV for this project? The best-case NPV? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

a-1

Compute the annual depreciation, using the equation as shown below:

Annual depreciation = Initial investment/ Estimated life

                                  = $2,200,000/ 5 years

                                  = $440,000

Hence, the annual depreciation is $440,000.

Compute the operating cash flows (OCF), using MS-excel as shown below:

The result of the above excel table is as follows:

Hence, the OCF is $1,500,800.

a-2

Compute the after-tax salvage value, using the equation as shown below:

After-tax salvage value = Salvage value*(1 – Tax rate)

                                      = $300,000*(1 – 0.22)

                                      = $234,000

Hence, the after-tax salvage value is $234,000.

Compute the net present value (NPV), using MS-excel as shown below:

The result of the above excel table is as follows:

Hence, the NPV is $3,247,659.92.

b.

Worst case:

Compute the after-tax salvage value, using the equation as shown below:

After-tax salvage value = Salvage value*(1 - Decrease in salvage value)*(1 – Tax rate)

                                      = $300,000*(1 - 0.15)*(1 – 0.22)

                                      = $198,900

Hence, the after-tax salvage value is $198,900.

Compute the worst-case net present value (NPV), using MS-excel as shown below:

The result of the above excel table is as follows:

Hence, the worst-case NPV is ($428,744.25).

Best case:

Compute the after-tax salvage value, using the equation as shown below:

After-tax salvage value = Salvage value*(1 + Increase in salvage value)*(1 – Tax rate)

                                      = $300,000*(1 + 0.15)*(1 – 0.22)

                                      = $269,100

Hence, the after-tax salvage value is $269,100.

Compute the best-case net present value (NPV), using MS-excel as shown below:

The result of the above excel table is as follows:

Hence, the best-case NPV is $6,924,064.08.