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 unlikelythe 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).[1]

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

Required (Please, provide supporting schedules for all your answers):

[20 points] Determine the NPV of the project. Clearly state the assumptions for your calculations. (Hint: since your will be evaluating more than one scenario, it will be on your best interest to use formulas and cell references in your Excel worksheets.)

[20 points] Using the information on the project and the assumptions you made in part I indicate the following:

[5 points] What is the Internal Rate of Return of the project?

[5 points] What is the after-tax payback period of the project?

[5 points] 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).

[5 points] 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?

[1] We are assuming the 2017 Tax Reform Legislation applies to this scenario.

Answer 1

Purchase Price		$1.10		(All figures are in million $)				Depreciation Schedule
Shipment Cost		$0.10						First Cost	$1.20		Year	1	2	3	4	5	6	7	8
Salvage Value		$0.05						Salvage	$0.05		% depn	14%	24%	17%	12%	9%	9%	9%	4%
Practical Capacity		1,200		(not in millions , just a number)				Economic Life		$1.15		$0.16	$0.28	$0.20	$0.14	$0.10	$0.10	$0.10	$0.05
Life of the machine		10
Working Capital		$0.025
Wages		$0.20
Percentage Decrease owing to productivity of labour						8%
Reduction in % of Unit Price negotiated with governmemt						3%
			Year	0	1	2	3	4	5	6	7	8	9	10
		Sales in units			1,100	1200	1200	1200	1200	1200	1200	1200	1200	1200
		Sales in $			$1.06	$1.15	$1.15	$1.15	$1.15	$1.12	$1.12	$1.12	$1.12	$1.12
		Vibranium Cost			($0.55)	($0.60)	($0.60)	($0.60)	($0.60)	($0.66)	($0.66)	($0.66)	($0.66)	($0.66)
		Wage Cost			($0.20)	($0.20)	($0.20)	($0.20)	($0.20)	($0.21)	($0.21)	($0.21)	($0.21)	($0.21)
		Training			($0.04)	-	-	-	-	-	-	-	-	-
		Depreciation			($0.16)	($0.28)	($0.20)	($0.14)	($0.10)	($0.10)	($0.10)	($0.05)	$0.00	$0.00
		EBIT			$0.10	$0.07	$0.15	$0.21	$0.25	$0.15	$0.15	$0.20	$0.25	$0.25
		Tax Rate	26%		$0.03	$0.02	$0.04	$0.05	$0.06	$0.04	$0.04	$0.05	$0.06	$0.06
		PAT			$0.08	$0.05	$0.11	$0.15	$0.18	$0.11	$0.11	$0.15	$0.18	$0.18
Cash Flow Schedule
		Net Income			$0.08	$0.05	$0.11	$0.15	$0.18	$0.11	$0.11	$0.15	$0.18	$0.18
		Intital Investment		($1.20)	-	-	-	-	-	-	-	-	-	-
		Working Capital Change			($0.03)	($0.03)	($0.03)	($0.03)	($0.03)	($0.03)	($0.03)	($0.03)	($0.03)	($0.03)
		Add Depreciation			$0.16	$0.28	$0.20	$0.14	$0.10	$0.10	$0.10	$0.05	$0.00	$0.05
Hurdle Rate		15%		($1.20)	$0.21	$0.31	$0.29	$0.27	$0.26	$0.19	$0.19	$0.17	$0.16	$0.21
		PV of Cash Flows		($1.20)	$0.19	$0.23	$0.19	$0.16	$0.13	$0.08	$0.07	$0.06	$0.05	$0.05
		NPV		$0.00
		IRR		0%
After Tax Payabck Period				9 years	Depending on assumptions that price negotiated with govt. is not reduced by 10% and Max decrease in productivity of labour is 8.33%
Hurdle Rate Sensitivity Can be checked by changing cell marked in yellow , there will be significant change in the IRR and NPV
Lowest Price that is acceptable to make the project viable						Using Goal Seek making NPV zero and changing the max reduction in unit price decrease % as variable we found that at 3% NPV =0
						Hence , max redction allowed is 3%
						Or , Lowest Selling Price			931.2