Question

Stark Industries is considering adding a vibranium shield to the Iron Man Suits the company manufactures for the U.S. Armed Forces. The equipment to build the shields has a purchase price of $1,100,000, and the company will spend $100,000 to ship the equipment to its plant and install it on the production floor. Stark Industries engineers expect the machine to have a $50,000 salvage value at the end of its 10-year life and a practical capacity of 1,200 shields per year. The new equipment requires an average of $25,000 investment in working capital to keep the equipment running efficiently; the $25,000 investment in working capital is fully recoverable at the end of the investment.

Stark Industries managerial performance evaluations include an 18% charge on invested capital. The company can obtain a 6% return on short-term investments and its current weighted average cost of capital is 15%.

Stark Industries’ negotiations with its union regarding the staffing of the new shield-manufacturing machine resulted in the firm agreeing to hire new workers and pay them $200,000 annually. The union agreement also stipulated that the employees have the option to request a salary revision after the fifth year of the agreement of up to 5% of the agreed salary. The company also agreed to invest $40,000 to train the new employees on the equipment when hired. Training the new employees will be on the job, which will likely reduce the output for the first year of the project by up to 100 shields; in the worst case scenario the decrease in output would be 25%.   

Each shield consumes $500 worth of vibranium (imported from Wakanda). Recent contract negotiations with Wakanda and King T’Challa have locked-in this cost for the next five years and specify an increase to $550 per shield thereafter. The current contract negotiated with the U.S. Armed Forces guarantees a price of $960 per shield for the first 5 years in the contract. Tony Stark, Stark Industries’ CEO, believe it is unlikely

the government will require a reduction of more than 10% of the price per shield in the next contract negotiation.

Common practice in the tax department of Stark Industries is to depreciate the full value of any acquired assets regardless of their salvage values. Pepper Potts (Stark Industries CFO) determined the equipment is 7-years class property (see depreciation percentages for this type of property in Exhibit 1). Stark Industries is subject to a 26% tax rate (21% corporate tax rate plus 5% blended rate of state taxes).

Exhibit I: Depreciation Schedule (in percentages) for 7-year property.

1. 14.29            

2. 24.49

3. 17.49

4. 12.49

5. 8.93

6. 8.92

7. 8.93

8. 4.46

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Cash Outflow
Initital Investment	1,100,000.00	-	-	-	-	-	-	-	-	-
Shipping Cost	100,000.00	-	-	-	-	-	-	-	-	-
Investment in WC*	25,000.00	-	-	-	-	-	-	-	-	-
Wages	200,000.00	200,000.00	200,000.00	200,000.00	200,000.00	210,000.00	210,000.00	210,000.00	210,000.00	210,000.00
Training Cost	40,000.00	-	-	-	-	-	-	-	-	-
Cost of Material	550,000.00	600,000.00	600,000.00	600,000.00	600,000.00	660,000.00	660,000.00	660,000.00	660,000.00	660,000.00
Total A	2,015,000.00	800,000.00	800,000.00	800,000.00	800,000.00	870,000.00	870,000.00	870,000.00	870,000.00	870,000.00
Cash Inflow
Salvage value	-	-	-	-	-	-	-	-	-	50,000.00
Investment in WC*	-	-	-	-	-	-	-	-	-	25,000.00
Revenue	1,056,000.00	1,152,000.00	1,152,000.00	1,152,000.00	1,152,000.00	1,036,800.00	1,036,800.00	1,036,800.00	1,036,800.00	1,036,800.00
Total B	1,056,000.00	1,152,000.00	1,152,000.00	1,152,000.00	1,152,000.00	1,036,800.00	1,036,800.00	1,036,800.00	1,036,800.00	1,111,800.00
Net Cash Flow B - A	(959,000.00)	352,000.00	352,000.00	352,000.00	352,000.00	166,800.00	166,800.00	166,800.00	166,800.00	241,800.00
PVF	0.87	0.76	0.66	0.57	0.50	0.43	0.38	0.33	0.28	0.25
NPV	(833,913.00)	266,163.00	231,446.00	201,257.00	175,006.00	72,112.00	62,706.00	54,527.00	47,415.00	59,769.00
Deprecitation	171,480.00	251,885.00	135,834.00	80,036.00	50,076.00	45,553.00	41,537.00	18,893.00	-	-
Net Profit Before Tax	(662,433.00)	14,278.00	95,612.00	121,221.00	124,930.00	26,559.00	21,170.00	35,635.00	47,415.00	59,769.00
Tax	-	3,712.00	24,859.00	31,517.00	32,482.00	6,905.00	5,504.00	9,265.00	12,328.00	15,540.00
NPAF	(662,433.00)	10,566.00	70,753.00	89,704.00	92,448.00	19,653.00	15,666.00	26,370.00	35,087.00	44,229.00
Depreciation Calculation
MachineCost	1,200,000.00	1,028,520.00	776,635.00	640,802.00	560,766.00	510,689.00	465,136.00	423,599.00
Depreciation rate	14.29	24.49	17.49	12.49	8.93	8.92	8.93	4.46
Depreciation	171,480.00	251,885.00	135,834.00	80,036.00	50,076.00	45,553.00	41,537.00	18,893.00
WDV	1,028,520.00	776,635.00	640,802.00	560,766.00	510,689.00	465,136.00	423,599.00	404,707.00
Total NPV	336,489.00

Using the information on the project and the assumptions you made in part I indicate the following:

a.            What is the Internal Rate of Return of the project?

b.            What is the after-tax payback period of the project?

c.             How sensitive is the viability of the project to the choice hurdle rate assumptions you made part I? (Indicate the NPV for each of the alternative hurdle rates you use).

d.            What will be the lowest price that Stark Industries may be able to accept upon contract renegotiation in year 5 that would continue to make the project viable?

Answer 1

I am going to calculate After Tax Internal Rate of Return here-

As we know from NPV Formula:-

NPV = C0 + C1/(1+R) + C2/(1+R)^2+.......+Cn/(1+R)^n

Here if we put NPV = 0, We will get R as IRR (Internal Rate of return). IRR can be calculated through Trail and Error method. I strongly recommend to use Financial Calculator or Excel for IRR calculation.

I calculated this value from Excel with after tax values shown in NPAT row from below table.

IRR = 15%.

Please refer below table.

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Net Cash Flow B - A	-959000.00	352000.00	352000.00	352000.00	352000.00	166800.00	166800.00	166800.00	166800.00	241800.00
Depriciation	171480.00	251885.00	135834.00	80036.00	50076.00	45553.00	41537.00	18893.00	0.00	0.00
NPBT	-1130480.00	100115.00	216166.00	271964.00	301924.00	121247.00	125263.00	147907.00	166800.00	241800.00
Tax	0.00	-26029.9	-56203.16	-70710.64	-78500.24	-31524.22	-32568.38	-38455.82	-43368	-62868
NPAT	-1130480.00	126144.90	272369.16	342674.64	380424.24	152771.22	157831.38	186362.82	210168.00	304668.00

Ans B

After tax payable period can be calculated with the help of above table Row NPAT.

Payable Period is a period when all our initial investment is received or earned.

In the above table if we calculate all our NPAT upto 5 year we will have -8867.06 remaining to earn for achieving our initial cash outflow. In next year we will receive 152771.22.

How much time it will take to earn 8867.06 in a year?

Simple it is 8867.06 / 152771.22 years = 0.06 year = 0.7 month = 21 days approx.

So our after tax payable period will be 5 years and 21 days.

Ans C

If in part A, IRR is calculated wrt Net cash flow only than IRR would have been 28% but it will not have shown tax and depriciation impact.

In the table given in question hurdle rate is takken as 15% and corresponding vales are provided in PVF row as 1/(1+R)^i, where i is the number of year, i.e. for year 5, i is 5 and PVF is 1/(1.15)^5 = 0.497.

Accordingly all the values are derived from this formula only.

We can change the value of hurdle rate and could find the different PVF values at different years.

Please refer the below table which i created from different hurdle rates from 9 to 15% for all 10 years.

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Hurdle Rate
PVF 1	0.869565217	0.756143667	0.657516232	0.571753246	0.497176735	0.432327596	0.37593704	0.326901774	0.284262412	0.247184706	15.00%
PVF 2	0.877192982	0.769467528	0.674971516	0.592080277	0.519368664	0.455586548	0.399637323	0.350559055	0.307507943	0.26974381	14.00%
PVF 3	0.884955752	0.783146683	0.693050162	0.613318728	0.542759936	0.480318527	0.425060644	0.376159862	0.332884833	0.294588348	13.00%
PVF 4	0.892857143	0.797193878	0.711780248	0.635518078	0.567426856	0.506631121	0.452349215	0.403883228	0.360610025	0.321973237	12.00%
PVF 5	0.900900901	0.811622433	0.731191381	0.658730974	0.593451328	0.534640836	0.481658411	0.433926496	0.390924771	0.352184479	11.00%
PVF 6	0.909090909	0.826446281	0.751314801	0.683013455	0.620921323	0.56447393	0.513158118	0.46650738	0.424097618	0.385543289	10.00%
PVF 7	0.917431193	0.841679993	0.77218348	0.708425211	0.649931386	0.596267327	0.547034245	0.50186628	0.46042778	0.422410807	9.00%

Please also find corresponding NPV vales for each year along with their summation to total NPV. (Here PVF 2 refers to NPV 2 and likewise).

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Total NPV
NPV 1	-833913.0435	266162.5709	231445.7138	201257.1424	175006.2108	72112.243	62706.29826	54527.21588	47414.97033	59769.26194	336488.5839
NPV 2	-841228.0702	270852.57	237589.9737	208412.2576	182817.7699	75991.83615	66659.5054	58473.25035	51292.32487	65224.05314	376085.4709
NPV 3	-848672.5664	275667.6325	243953.6571	215888.1921	191051.4975	80117.13038	70900.11538	62743.46494	55525.19021	71231.46258	418405.7764
NPV 4	-856250	280612.2449	250546.6472	223702.3636	199734.2532	84506.07101	75451.84912	67367.72243	60149.75217	77853.12861	463674.0323
NPV 5	-863963.964	285691.0965	257379.3662	231873.3029	208894.8675	89178.09146	80340.62294	72378.93958	65206.25188	85158.20697	512136.782
NPV 6	-871818.1818	290909.0909	264462.8099	240420.7363	218564.3057	94154.25153	85594.77412	77813.43102	70739.48274	93224.36738	564065.0678
NPV 7	-879816.5138	296271.3576	271808.585	249365.6743	228775.848	99457.39012	91245.31204	83711.29545	76799.35362	102138.9331	619757.2355

From above it is clear that as Hurdle rate decreases our NPV Increases and vice versa.

Also note that this NPV will become 0 at hurdle rate 28 which is IRR for this Net cash flows.

Ans D

We will take hurdle rate 15%, as per question table for solution.

If after year 5, we put the net cash flow to 0 upto year 9 from year 6 and 75000 cash inflow in year 10 (Salvage value + Investment in working capital) than our IRR will be 18% for Net cash flows in Ans A table.

Also refer below table.

Net Cash Flow B - A

-959000.00

352000.00

352000.00

352000.00

352000.00

0.00

0.00

0.00

0.00

75000.00

So basically Stark can reduce the price so that he can have no profit no loss situation in next 5 years.

i.e. Quantity * Price = Cash Outflow

so 1200 * Price = 870000

So the lowest price he can go to is 725.

Thank You!!