Question

Consider a project to supply Detroit with 27,000 tons of machine screws annually for automobile production. You will need an initial $5,000,000 investment in threading equipment to get the project started; the project will last for 5 years. The accounting department estimates that annual fixed costs will be $1,200,000 and that variable costs should be $225 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the 5-year project life. It also estimates a salvage value of $575,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $332 per ton. The engineering department estimates you will need an initial net working capital investment of $480,000. You require a return of 11 percent and face a tax rate of 22 percent on this project.

  

a-1.	What is the estimated OCF for this project? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
a-2.	What is the estimated NPV for this project? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
b.	Suppose you believe that the accounting department’s initial cost and salvage value projections are accurate only to within ±10 percent; the marketing department’s price estimate is accurate only to within ±15 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? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

Answer 1

a1.

	Amount	Notes
Sales	8,964,000	27000 tons @332
Variable cost	(6,075,000)	27000 tons @225
Fixed cost	(1,200,000)
Net Gain before depreciation and tax	1,689,000	A
Net gain after tax and before depreciation	1,317,420	A x (1-0.22)
Tax saving on depreciation	194,700	(5,000,000-575,000)/5 years x 0.22 tax rate
Operating cash flow	1,512,120

a2.

t	Cash flow	Present Value Factor= 1 / (1+r)t	Present value
0	(5,480,000)	1	(5,480,000)
1	1,512,120	0.901	1,362,270
2	1,512,120	0.812	1,227,271
3	1,512,120	0.731	1,105,649
4	1,512,120	0.659	996,080
5	1,960,620	0.593	1,163,533	Including salvage value net of tax, $575,000x(1-0.22)
	Net Present value		374,803

b.

	Worst Case			Best Case
	Amount	Notes		Amount	Notes
Sales	8,829,540	15% below actual sales		10,308,600	15% above actual sales
Variable cost	(6,075,000)	27000 tons @225		(6,075,000)	27000 tons @225
Fixed cost	(1,200,000)			(1,200,000)
Net Gain before depreciation and tax	1,554,540	A		3,033,600	A
Net gain after tax and before depreciation	1,212,541	A x (1-0.22)		2,366,208	A x (1-0.22)
Tax saving on depreciation	219,230	(5,500,000-517,500)/5 years x 0.22 tax rate		170,170	(4,500,000-632,500)/5 years x 0.22 tax rate
Operating cash flow	1,431,771			2,536,378

t	Present Value Factor= 1 / (1+r)t		Cash flow Worst Case		Present value Worst Case	Cash flow best Case		Present value Best Case
0	1		(6,004,000)	(5,000,000x(1+.1)+48,0000x(1+.05)	(6,004,000)	(4,956,000)	(5,000,000x(1-.1)+48,0000x(1-.05)	(4,956,000)
1	0.901		1,431,771		1,289,884	2,536,378		2,285,025
2	0.812		1,431,771		1,162,058	2,536,378		2,058,581
3	0.731		1,431,771		1,046,899	2,536,378		1,854,578
4	0.659		1,431,771		943,152	2,536,378		1,670,791
5	0.593		1,835,031	Including tax on salvage value net of tax	1,089,002	2,984,878	Including tax on salvage value net of tax	1,771,380
	Net Present value				(473,006)			4,684,355