Question

Square Manufacturing is considering investing in a robotics manufacturing line. Installation of the line will cost an estimated $9.7 million. This amount must be paid immediately even though construction will take three years to complete (years 0, 1, and 2). Year 3 will be spent testing the production line and, hence, it will not yield any positive cash flows. If the operation is very successful, the company can expect after-tax cash savings of $6.7 million per year in each of years 4 through 7. After reviewing the use of these systems with the management of other companies, Square’s controller has concluded that the operation will most probably result in annual savings of $4.9 million per year for each of years 4 through 7. However, it is entirely possible that the savings could be as low as $2.5 million per year for each of years 4 through 7. The company uses a 16 percent discount rate. Use Exhibit A.8.

Required:

Compute the NPV under the three scenarios. (Round PV factor to 3 decimal places. Enter your answers in thousands of dollars. Negative amounts should be indicated by a minus sign.)

1.best case

2.Expected

3. worst case

Answer 1

Answer 1)

Calculation of Net present value in Best case

Net Present value = Present value of cash inflows – Present value of cash outflows

                                  = $ 12,010,889 - $ 9,700,000

                                  = $ 2,310,889

Therefore net present value in Best case is $ 2,310,889.

Working Note:

Calculation of present value of cash inflows

Present value of cash inflows = (cash inflows in Year 4 X present value factor at 16% for year 4) + (cash inflows in Year 5 X present value factor at 16% for year 5) + (cash inflows in Year 6 X present value factor at 16% for year 6) + (cash inflows in Year 7 X present value factor at 16% for year 7)

                                  = ($6,700,000 X 0.55259) + ($6,700,000 X 0.47611) + ($6,700,000 X 0.41044) + ($6,700,000 X 0.35383)

                                                = $ 12,010,889

Answer 2)

Calculation of Net present value in Expected case

Net Present value = Present value of cash inflows – Present value of cash outflows

                                  = $ 8,784,083 - $ 9,700,000

                                  = - $ 915,917

Therefore net present value in Expected case is - $ 915,917.

Working Note:

Calculation of present value of cash inflows

Present value of cash inflows = (cash inflows in Year 4 X present value factor at 16% for year 4) + (cash inflows in Year 5 X present value factor at 16% for year 5) + (cash inflows in Year 6 X present value factor at 16% for year 6) + (cash inflows in Year 7 X present value factor at 16% for year 7)

                                  = ($4,900,000 X 0.55259) + ($4,900,000 X 0.47611) + ($4,900,000 X 0.41044) + ($4,900,000 X 0.35383)

                                                = $ 8,784,083

Answer 3)

Calculation of Net present value in Worst case

Net Present value = Present value of cash inflows – Present value of cash outflows

                                  = $ 4,481,675 - $ 9,700,000

                                  = - $ 5,218,325

Therefore net present value in Worst case is - $ 5,218,325.

Working Note:

Calculation of present value of cash inflows

Present value of cash inflows = (cash inflows in Year 4 X present value factor at 16% for year 4) + (cash inflows in Year 5 X present value factor at 16% for year 5) + (cash inflows in Year 6 X present value factor at 16% for year 6) + (cash inflows in Year 7 X present value factor at 16% for year 7)

                                  = ($2,500,000 X 0.55259) + ($2,500,000 X 0.47611) + ($2,500,000 X 0.41044) + ($2,500,000 X 0.35383)

                                                = $ 4,481,675