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 ton; 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:

1) What is the base case scenario NPV of the Detroit Automotive Solutions contract? What is the IRR for the base-case scenario? What is the payback period for the base-case scenario of the Detroit Contract?

2) What is the sensitivity of the project NPV to changes in the quantity supplied ΔNPV/ΔQ? What is the sensitivity of the project NPV to changes in the variable costs ΔNPV/ΔVC? 3) What is the sensitivity of the project NPV to changes in the fixed costs ΔNPV/ΔFC? Which of these items have the greatest impact on the project’s NPV?

4) Cynthia Barlow is a little unsure about Detroit Automotive Solutions’ actual machine screw requirements. So, she also wants to know the minimum level of output that you recommend the company should not drop below under the base case scenario. (Calculate both accounting and financial break-even but recommend which of these estimates is most useful.)

5) Due to potential changes in the economic environment, Cynthia Barlow is not as confident in the original projections. So, she request that you evaluate not only the base-case scenario, but also, the worst-case, and best-case scenarios for the firm. 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?

6) 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? Do you recommend that the firm should pursue the contract with Detroit Automotive Solutions or the contract with Automoville Inc.? Why?

Answer 1

Q1) NPV, IRR and Payback Period

The Base Case NPV of the project is $3,734,696

The IRR of the project is 38.42%. The payback period is 2.38 years.

According to the above calculations, this project is better than the Automoville Inc project

Q2) Sensitivity

Sensitivity to changes in Quantity supplied is 37.85%

Sensitivity to changes in variable costs is 16.22%

Q3) Sensitivity to changes in Fixed costs

Sensitivity to changes in Fixed costs is 147.31%

Variable costs have the highest sensititvity

Q4) Break even

The break even sales is $3,083,333