Question

Bombardier, after spending $250,000 on a feasibility study, has determined that its customers will be willing to pay more money for the C Series model if Bombardier invests in a manufacturing technology upgrade that can enhance the safety of the engine. Bombardier realizes that the delays in the C Series program are likely costing them potential sales of the C Series jets. The feasibility study allowed management to better understand the implementation costs of the new technology as well as the potential payoff. Thus, they see the opportunity to make a short-term investment in the engine technology that will affect the next eight years of production in order to improve their overall offering to their customers.

Because the C Series production facilities are already covered in original cost estimates, no additional costs for production facilities are required. However, the required new machinery will cost $2,100,000 and will be subject to capital cost allowance depreciation (Asset Class 8, 20% CCA Rate). When the C Series program expires after year eight, Bombardier executives figure there will be $396,361.73 in salvage on the equipment. Sales across the eight years of the C Series program are projected to be 19 units, 23 units, 30 units, 44 units, 55 units, 35 units, 37 units, and 40 units.

Bombardier expects that the price to their customers will start at an additional $125,000 with 3.5 per cent increases per year, as they wish to keep their prices competitive. Material costs of production are expected to be $67,500 per unit, growing at four per cent a year. Fixed costs per annum will amount to $670,000. The corporate tax rate Bombardier is subject to is 26.4 per cent.

Finally, Bombardier requires a maintained investment in working capital of $365,000 at the beginning of the project. This will stay at 14 per cent of sales at the end of each year, and reduces to 0 by the project's end; therefore, the investment in working capital is fully recovered by the project's end. As the company will be purchasing raw materials prior to production and sales delivery, they must create an investment in inventory as well as

maintaining some cash as a buffer against unforeseen expenses. If the firm has negative taxable income from the project in a given year, please assume that the firm has positive income from other projects, so that the loss can be written off (as a tax benefit) against this other project income in the same year.

Questions

1. What is the Internal Rate of Return on the project?

2. What is the Net Present Value of the project if the required rate of return (Weighted

   Average Cost of Capital) is equal to 3.90 per cent?

3. By how much would the Net Present Value of the project change if unit sales were 25

   per cent less than expected (round down toward zero the number of units; the WACC is still 3.90%)?

Answer 1

Answer:

Before computing the Internal Rate of Return (IRR) and Net Present Value (NPV), the yearly free cash flow till the life of the project is to be determined. The following table shows the yearly free cash flow from this project.

Note 2 - Working capital for cash flow will be working capital of previous year minus working capital of current year.

1. What is the IRR for the project?

Based on the Free cash flows for Year 0 to Year 8 as computed above, IRR (by using IRR function in Excel) will be 34% p.a. Alternatively, it can be found out using Trial and error method as well.

2. What is the NPV of the project.

NPV

Year   Free cash flow - A   Discounting factor @ 3.9% - B   PV - AxB
Year 0          (2,465,000.00)                    1.000          (2,465,000.00)
Year 1                398,900.00                    0.962                383,926.85
Year 2                524,298.90                    0.926                485,677.35
Year 3                785,472.33                    0.892                700,300.20
Year 4             1,308,654.48                    0.858            1,122,956.17
Year 5             1,917,140.23                    0.826            1,583,347.15
Year 6             1,633,621.67                    0.795            1,298,548.57
Year 7             1,329,621.20                    0.765            1,017,229.86
Year 8             2,792,312.48                    0.736            2,056,078.24

NPV (Sum)           $ 6,183,064.40
3) How much would NPV change, if sales drop by 25%.

The following table shows the annual free cash flow for Year 0 to Year 8, when the sales are reduced by 25%.

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8
Sales in Units - A		14	17	23	33	41	26	28	30
Selling price per unit - B		$    125,000.00	$    129,375.00	$    133,903.13	$    138,589.73	$    143,440.38	$    148,460.79	$    153,656.92	$    159,034.91
Sales - C = AxB		$ 1,781,250.00	$ 2,231,718.75	$ 3,012,820.31	$ 4,573,461.23	$ 5,916,915.47	$ 3,897,095.69	$ 4,263,979.41	$ 4,771,047.24
Material Cost per Unit - D		$      67,500.00	$      70,200.00	$      73,008.00	$      75,928.32	$      78,965.45	$      82,124.07	$      85,409.03	$      88,825.40
Total Material Cost - E = AxD		$    961,875.00	$ 1,210,950.00	$ 1,642,680.00	$ 2,505,634.56	$ 3,257,324.93	$ 2,155,756.86	$ 2,370,100.69	$ 2,664,761.85
Fixed Cost - F		$    670,000.00	$    670,000.00	$    670,000.00	$    670,000.00	$    670,000.00	$    670,000.00	$    670,000.00	$    670,000.00
Depreciation (Note 1) - G		$    210,000.00	$    378,000.00	$    302,400.00	$    241,920.00	$    193,536.00	$    154,828.80	$    123,863.04	$      99,090.43
Earnings Before Tax (C-E-F-G)		$     (60,625.00)	$     (27,231.25)	$    397,740.31	$ 1,155,906.67	$ 1,796,054.54	$    916,510.03	$ 1,100,015.69	$ 1,337,194.95
Less: Tax @26.4%		$     (16,005.00)	$       (7,189.05)	$    105,003.44	$    305,159.36	$    474,158.40	$    241,958.65	$    290,404.14	$    353,019.47
Profit After Tax		$     (44,620.00)	$     (20,042.20)	$    292,736.87	$    850,747.31	$ 1,321,896.14	$    674,551.38	$    809,611.55	$    984,175.48
Add: Depreciation		$    210,000.00	$    378,000.00	$    302,400.00	$    241,920.00	$    193,536.00	$    154,828.80	$    123,863.04	$      99,090.43
Cash Flow - H	$                    -	$    165,380.00	$    357,957.80	$    595,136.87	$ 1,092,667.31	$ 1,515,432.14	$    829,380.18	$    933,474.59	$ 1,083,265.92
Working Capital	$     365,000.00	$    249,375.00	$    312,440.63	$    421,794.84	$    640,284.57	$    828,368.17	$    545,593.40	$    596,957.12	$                   -
Working Capital for cash flow - I (Note 2)	$    (365,000.00)	$    115,625.00	$     (63,065.62)	$ (109,354.22)	$ (218,489.73)	$ (188,083.59)	$    282,774.77	$    (51,363.72)	$    596,957.12
Plant & Equipment - J	$ (2,100,000.00)								$    396,361.73
Free cash flow H+I+J	$ (2,465,000.00)	$    281,005.00	$    294,892.18	$    485,782.65	$    874,177.58	$ 1,327,348.55	$ 1,112,154.95	$    882,110.86	$ 2,076,584.76

NPV-

Year   Free cash flow - A   Discounting factor @ 3.9% - B   PV - AxB
Year 0          (2,465,000.00)                    1.000          (2,465,000.00)
Year 1                281,005.00                    0.962                270,457.17
Year 2                294,892.18                    0.926                273,169.47
Year 3                485,782.65                    0.892                433,107.15
Year 4                874,177.58                    0.858                750,131.62
Year 5             1,327,348.55                    0.826            1,096,244.03
Year 6             1,112,154.95                    0.795                884,040.20
Year 7                882,110.86                    0.765                674,861.01
Year 8             2,076,584.76                    0.736            1,529,062.66

NPV (Sum)         $ 3,446,073.32
Change in NPV due to 25% reduction in sales = $ 6,183,064.40 - $ 3,446,073.32 = $ 2,736,991.08