Question

A company is considering replacement of manufacturing equipment with computer controlled equipment, at a cost of $500,000, replacing equipment with a scrap value of $50,000. This will reduce defect costs by $150,000 a year. At the end of 7 years, the equipment will be replaced and will have a scrap value of $100,000. The interest charges for financing the purchase will be $25,000 a year. The new system will be housed in a building that is currently unused, with an overhead value of $10,000 a year. Utility costs will be unchanged. Machine operators will require training of $1000 each for 4 workers. These workers are scheduled for a raise of $3000 each. Because the new equipment technology is well-established for its intended use, the risk premium for the project is considered to be 2 percentage points less than the company’s WACC of 8%.                 

1.1 List the investment facts for the project:

NOTE: List all of the financial details associated with the project and designate which should be included (and which ignored) in calculating the project’s cash flows and its cost of capital.

Life of the project: 7 years

Interest rate for the project:  6% (8-2) (cost of capital to the firm adjusted for project risk)

PVIF for the project:     0.666

PVIFA for the project:     5.582

A. Initial investment: (include all cash flows - positive and negative - that occur at the beginning of the project)

B. Future cash flows: (negative and positive)

C. Lump sum: (one time)

D. Annuity: (repeated annually)

E. Costs that you will ignore: (sunk cost or otherwise)

1.2. A. Using the relevant net cash flows and cost of capital from A above, calculate the NPV for the project. (use the NPV formula and the PV tables)

Please Answer:

1.1 A.

1.1 B.

1.1 C.

1.1 D

1.1 E.

1.2 A.

Answer 1

		Year	Year	Year	Year	Year	Year	Year	Year
		0	1	2	3	4	5	6	7
Equipment Cost		-5,00,000
Scrap Value of old equipment		50,000
Scrap Value of new equipment									1,00,000
Worker Training		-4,000
Reduction in Defect Costs			1,50,000	1,50,000	1,50,000	1,50,000	1,50,000	1,50,000	1,50,000
Financing Costs			-25000	-25000	-25000	-25000	-25000	-25000	-25000
Total Cash Flow		-4,54,000	1,25,000	1,25,000	1,25,000	1,25,000	1,25,000	1,25,000	2,25,000
Cost Of Capital	6%
PVIF		1	0.9434	0.8900	0.8396	0.7921	0.7473	0.7050	0.6651
Cash Flows		-4,54,000	1,17,925	1,11,250	1,04,952	99,012	93,407	88,120	1,49,638
Total NPV		3,10,303

Questions from 1.1 A to 1.1 D & 1.2 A have been effectively answered in the table.

1.1 E Cost of building is being ignored. It is currently unused. The overhead costs are going to be incurred whether or not this project is implemented. There is no incremental overhead building costs due to this project.

Workers' raise is being ignored. They will get a raise irrespective of the project being implemented.

Please feel free to comment in case you need any further clarifications. Thanks.