Question

A successful computer business company is considering a new product line that require a new machine. It will cost $36,000,000. It will be fully depreciated to a zero book value on a straight line basis over 4 years. The project will generate $100,000,000 in sales each year for 4 years. Variable costs are 75% of sales and fixed costs are $8,500,000 per year for 4 years. To get the project started and for each year, net operating working capital (NOWC) is 1% of the next year's sales. The company will have $5,000,000 annually in interest expense as part of the financing. Tax rate is 25%. The company's financial advisor estimates the cost of capital (required return) as 14%. Note: Variable and fixed costs do not include depreciation or interest expense. a) Calculate the net present value (NPV) and internal rate of return (IRR). b) Should they consider the new line? Why? c) The financial manager is concerned about their estimates and conducts a scenario analysis. Variable costs could be 70%, 75% (expected) or 80% of sales and the cost capital could be 10%, 14%(expected) or 16%. Use a data table to analyze the NPV. What can you conclude and why is this important for evaluating the project?                                                                     

Answer 1

Based on the given data, pls find below steps, workings and answers:

The Interest expense is not required to be considered in this workings as the cost of capital already includes the cost of debt with which the Present value is being arrived;

a) The Net Present Value (NPV) for this new line of machine is $ 5613042.45 and the Internal Rate of Return (IRR) is 21.22%;

b) Since the NPV is positive and the IRR is higher than the cost of capital , the project is recommeded for investment.

c) Sensitivity is common among any projects with future projections based on best judgement estimates; However, there are chances that these estimates might get impacted due to internal or external factors. Hence, a sensitivity analysis establish the picture of extremes of risk and positive sides based on the fluctuations in the factors used for estimating the cash flows;

In this case, it is evident that if the variable costs increase to 80% of the total sales, the project's NPV is negative at any given costs of capital %; Hence, in this case, the project feasibility is dependent on the confirmity of the increase in the variable cost %;

Year 1 Year 2 Year 3 Year 4 Year 0 -3,60,00,000 -10,00,000 -10,00,000 -10,00,000 -10,00,000 -10,00,000 75% Project (in $) New Production Line Net Working Capital Increase Change in Working Capital Revenue Variable Costs Fixed Costs EBIDT Depreciation EBT Tax@ 25% Net Income 10,00,00,000 10,00,00,000 7,50,00,000 7,50,00,000 85,00,000 85,00,000 1,65,00,000 1,65,00,000 90,00,000 90,00,000 75,00,000 75,00,000 18,75,000 18,75,000 56,25,000 56,25,000 10,00,00,000 10,00,00,000 7,50,00,000 7,50,00,000 85,00,000 85,00,000 1,65,00,000 1,65,00,000 90,00,000 90,00,000 75,00,000 75,00,000 18,75,000 18,75,000 56,25,000 56,25,000 -3,70,00,000 1 Cash Flows (Net Income add back Depreciation) Discounting Factor Discounted Cash Flow Cumulative Discounted Cash Flow 1,46,25,000 0.8772 1,28,28,947 -2,41,71,053 1,46,25,000 0.7695 1,12,53,463 -1,29,17,590 1,46,25,000 0.6750 98,71,458 -30,46,132 1,46,25,000 0.5921 86,59,174 56,13,042 -3,70,00,000 -3,70,00,000 NPV IRR 56,13,042.45 21.22% Discounting Factor 14.00% Scenario Analysis: Cost of Capital 56,13,042.45 10% Variable Costs 70% 75% 80% 2,12,46,277.58 93,59,282.15 -25,27,713.27 1,65,39,463.60 56,13,042.45 -53,13,378.69 1,44,16,569.23 39,23,391.83 -65,69,785.56 14% 16%