Question

North State Manufacturing is considering a contract for a project to supply Detroit Automotive Solutions with 30,000 tons of machine screws annually for automobile production. North State Manufacturing will need an initial $4,500,000 investment in threading equipment to get the project started; the project will last for six years. The accounting department estimates that annual fixed costs will be $925,000 and that variable costs should be $280 per tons accounting will depreciate the initial fixed asset investment straight-line to zero over the six-year project life. It also estimates a salvage value of $500,000 after dismantling costs. The initial investment and salvage value are accurate within +/- 8% of the initial projections. The marketing department estimates that the automakers will approve the contract at a selling price of $400 per ton. The engineering department estimates that North State Manufacturing will need an initial net working capital investment of $500,000, but management expects to recover their net working capital in the terminal year of the project. Consider, the units produced, sales price, variable costs, and fixed costs to be accurate within +/- 10% of the projections. Also consider, that the North State Manufacturing is offered a similar contract with Automoville, Inc. that has an expected net present value of $850,000, a payback period of 4.2 years, and IRR of 25%, but it comes with a non-compete clause that will not allow you to pursue the contract with Detroit Automotive Solutions. North State Manufacturing requires a return of 13.75 percent and face a marginal tax rate of 30 percent on this project. You are a Financial Analyst in the Corporate Finance Division and have been tasked by North State Manufacturing’s VP-Capital Projects, Cynthia Barlow, to evaluate this project. The VP would like to know the following in an executive summary:

Due to potential changes in the economic environment, Cynthia Barlow is not as confident in the original projections. So, she request that you evaluate the worst-case. What is the worst-case scenario NPV of the Detroit Automotive Solutions contract?

What is the best-case scenario NPV of the Detroit Automotive Solutions contract?

Further, you contact your Economic Forecasting Division and they provide you with the estimated probabilities of a 30, 50%, and 20% for the best-case, base-case, and worst-case scenarios, respectively. What is the expected NPV payoff of the Detroit Automotive Solutions contract?

Answer 1

Base case NPV :

Following details are given:

Calculation of Base Case NPV is as under :

Worst Case NPV:

Here, following data is given          
Rate of Tax   = 30%  
Discounting rate   = 13.75%  
Estimated Cost of the project (Base case +8%) = $   4860000  
Working capital   = $   500000  
Estimated Residual Value (Base Case - 8%) = $   460000  
Life of Project =     6  
Thus, depreciation as per staright line method = (4860000/6) = $   810000   per year

Calculation of NPV is as under :

Best Case NPV :

Here, following data is given

Calculation of Best Case NPV is as under:

Expected NPV payoffs when probability is given :