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:
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?
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?
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?

Answer 1

Following are given below :

I. The Best Case Scenario (Unit Price is up 10%, Unit Sales is up 10%, Fixed costs is down 10%, Variable Costs is down 10%)

II. The Sensitivity of NPV to quantity supplied

III. The Sensitivity of NPV to variable costs

IV. The Sensitivity of NPV to fixed costs

Basis

• All costs & values that impact cash flow negatively are shown in negative values
• Fixed Costs are given.
• Sales and variable costs are derived from units sold and the respective per unit revenue and variable costs
• Depreciation = (Equipment cost ) / Number of years of depreciation
• Depreciation = (4,500,000) / 6 = 750,000
• Tax is 30% on EBIT
• Working Capital for year 0 = 500,000 . If Working capital is increasing, it will bring down cash flow, thus shown as negative
• In the terminal year, all investments in WC are returned back = 500000
• The salvage value of equipment is 500,000 . But since the equipment is already depreciated to zero, (Salvage value is not counted while calculating depreciation), a tax needs to be paid = (Salvage Value - Book Value)* Tax rate
• Tax on Salvaged Equipment = (500000 - 0)* 30% = 150,000
• Cash Flow = (Net Income + Depreciation + Net working capital investments + Return of Net working capital + Capital Expenditure + Salvage Value) *
• *Sign of cash flows are important here. One which increases CF is positive, other which decreases Cf is negative
• PV of cash flows = CFt/ (1+k)^t
• where CFt is cash flow in year t, k = Cost of capital (13.75%) & t is the year of Cash flow
• NPV = Sum of PV of all future cash flows - Investment
• IRR is calculated using Excel function of IRR
• Pay Back Period = The last year in which cumulative CF are negative (t) + (Cumulative Cash Flow in year t / Cash Flow in next year (t+1)

I. Best Case Scenario

NPV = $10,995,596

IRR = 77.58%

PBP = 1.25 years

Revenue forecast	0	1	2	3	4	5	6
Units sold (A)		33000	33000	33000	33000	33000	33000
Sales Price / Unit (B)		440	440	440	440	440	440
Variable cost/ Unit (C		252	252	252	252	252	252
Revenues (D = A x B)		14,520,000	14,520,000	14,520,000	14,520,000	14,520,000	14,520,000
Variable costs (E = A x C)		(8,316,000)	(8,316,000)	(8,316,000)	(8,316,000)	(8,316,000)	(8,316,000)
Fixed Costs (F)		(832,500)	(832,500)	(832,500)	(832,500)	(832,500)	(832,500)
Depreciation (G = (M) /6)		(750,000)	(750,000)	(750,000)	(750,000)	(750,000)	(750,000)
EBIT (H = D + E + F + G)		4,621,500	4,621,500	4,621,500	4,621,500	4,621,500	4,621,500
Taxes @ 30% (I = H x 30%)		(1,386,450)	(1,386,450)	(1,386,450)	(1,386,450)	(1,386,450)	(1,386,450)
Net Income (J = H - I)		3,235,050	3,235,050	3,235,050	3,235,050	3,235,050	3,235,050
Depreciation (G)		750,000	750,000	750,000	750,000	750,000	750,000
Net Working Capital Investments (K)	(500,000)
Return of Net working Capital (L)							500,000
Capital Expenditure in Plant & Mach(M)	(4,500,000)
Salvage Value of Equipment N							500,000
Tax on Salvaged Equipment O							(150,000)
Free Cash Flow (FCF = J+G+K+L+M+N +O)	(5,000,000)	3,985,050	3,985,050	3,985,050	3,985,050	3,985,050	4,835,050
Cost of Capital (Discount Rate) R	13.75%
PV Of Free Cash Flow	(5,000,000)	3,503,341	3,079,860	2,707,569	2,380,281	2,092,554	2,231,992
NPV (Sum of PV of all CF)	10,995,596
IRR	77.58%
PBP	1.25

II. The Sensitivity of NPV to quantity supplied

Sensitivity of Quantity Supplied
Variation in Units	Units Supplied	NPV	% Change in NPV
-10%	27,000	2,618,323	-27.4%
-5%	28,500	3,111,668	-13.7%
0%	30,000	3,605,013	0.0%
5%	31,500	4,098,358	13.7%
10%	33,000	4,591,703	27.4%

III. The Sensitivity of NPV to variable costs

Sensitivity of Variable Cost
Variation in Variable Costs	Variable costs	NPV	% Change in NPV
-10%	252	5,907,290	63.9%
-5%	266	4,756,151	31.9%
0%	280	3,605,013	0.0%
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