Question

Consider a project to supply Detroit with 20,000 tons of machine screws annually for automobile production. You will need an initial $3,400,000 investment in threading equipment to get the project started; the project will last for four years. The accounting department estimates that annual fixed costs will be $800,000 and that variable costs should be $180 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the four-year project life. It also estimates a salvage value of $620,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $300 per ton. The engineering department estimates you will need an initial net working capital investment of $340,000. You require a return of 11 percent and face a marginal tax rate of 38 percent on this project. a-1 What is the estimated OCF for this project? (Do not round intermediate calculations. Round your answer to the nearest whole number, e.g., 32.) OCF $ 1,315,000 a-2 What is the estimated NPV for this project? (Do not round intermediate calculations. Round your answer to 2 decimal places, e.g., 32.16.) NPV $ 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 are your worst-case and best-case NPVs for this project? (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Round your answers to 2 decimal places, e.g., 32.16.) Worst-case $ Best-case $

Answer 1

Detroit	0	1	2	3	4
Investment	-$3,400,000
NWC	-$340,000				$340,000
Salvage					$620,000
Sales		$6,000,000	$6,000,000	$6,000,000	$6,000,000
VC		-$3,600,000	-$3,600,000	-$3,600,000	-$3,600,000
FC		-$800,000	-$800,000	-$800,000	-$800,000
Depreciation		-$850,000	-$850,000	-$850,000	-$850,000
EBT		$750,000	$750,000	$750,000	$750,000
Tax (38%)		-$285,000	-$285,000	-$285,000	-$285,000
Net Income		$465,000	$465,000	$465,000	$465,000
Cash Flows	-$3,740,000	$1,315,000	$1,315,000	$1,315,000	$2,039,400
NPV	$816,900.80

OCF = Net Income + Depreciation = 465,000 + 850,000 = $1,315,000

NPV can be calculated using NPV function in excel or calculator with 11% discount rate.

NPV = $816,900.80

Worst-case NPV will be when initial cost and NWC are higher, while salvage value and price are lower.

Detroit	0	1	2	3	4
Investment	-$3,910,000
NWC	-$357,000				$357,000
Salvage					$527,000
Sales		$5,400,000	$5,400,000	$5,400,000	$5,400,000
VC		-$3,600,000	-$3,600,000	-$3,600,000	-$3,600,000
FC		-$800,000	-$800,000	-$800,000	-$800,000
Depreciation		-$977,500	-$977,500	-$977,500	-$977,500
EBT		$22,500	$22,500	$22,500	$22,500
Tax (38%)		-$8,550	-$8,550	-$8,550	-$8,550
Net Income		$13,950	$13,950	$13,950	$13,950
Cash Flows	-$4,267,000	$991,450	$991,450	$991,450	$1,675,190
NPV	-$740,679.50

Best-case NPV will be when initial cost and NWC are lower, while salvage value and price are higher.

Detroit	0	1	2	3	4
Investment	-$2,890,000
NWC	-$323,000				$323,000
Salvage					$713,000
Sales		$6,600,000	$6,600,000	$6,600,000	$6,600,000
VC		-$3,600,000	-$3,600,000	-$3,600,000	-$3,600,000
FC		-$800,000	-$800,000	-$800,000	-$800,000
Depreciation		-$722,500	-$722,500	-$722,500	-$722,500
EBT		$1,477,500	$1,477,500	$1,477,500	$1,477,500
Tax (38%)		-$561,450	-$561,450	-$561,450	-$561,450
Net Income		$916,050	$916,050	$916,050	$916,050
Cash Flows	-$3,213,000	$1,638,550	$1,638,550	$1,638,550	$2,403,610
NPV	$2,374,481.10