Question

Howell Petroleum is considering a new project that complements its existing business. The machine required for the project costs $3.82 million. The marketing department predicts that sales related to the project will be $2.52 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. Howell also needs to add net working capital of $170,000 immediately. The additional net working capital will be recovered in full at the end of the project’s life. The corporate tax rate is 40 percent. The required rate of return for the project is 14 percent.

[Use Excel to answer the questions. Without Excel worksheet, no credit will be earned.]

1. What is the NPV and IRR of the project? Is the project acceptable?

2. Do the following scenario analyses:

1. What if the sales level is 50% higher than the current estimate? Compute the NPV and IRR of the project.
2. What if the sales level is 75% higher than the current estimate? Compute the NPV and IRR of the project.
3. What if the sales level is 50% lower than the current estimate? Compute the NPV and IRR of the project.
4. What if the sales level is 75% lower than the current estimate? Compute the NPV and IRR of the project.

3. What is the breakeven price of the machine? (What price of the equipment will make the NPV equal zero?)

Answer 1

1). Base-case NPV and IRR:

`	Year (n)	0	1	2	3	4
	Initial investment (I) part	(3,820,000)
	Sales		2,520,000	2,520,000	2,520,000	2,520,000
25%*Sales	Less: COGS & other op. expenses		(630,000)	(630,000)	(630,000)	(630,000)
(I/4)	Less: depreciation (D)		(955,000)	(955,000)	(955,000)	(955,000)
(Sales - COGS - D)	Operating profit (OP)		935,000	935,000	935,000	935,000
(40%*OP)	Less: Tax @40%		(374,000)	(374,000)	(374,000)	(374,000)
(OP - Tax)	Net income (NI)		561,000	561,000	561,000	561,000
	Add: depreciation (D)		955,000	955,000	955,000	955,000
(NI + D)	Operating cash flow (OCF)		1,516,000	1,516,000	1,516,000	1,516,000
	Add: Increase in NWC	(170,000)				170,000
(I + OCF + Increase in NWC)	FCF	(3,990,000)	1,516,000	1,516,000	1,516,000	1,686,000
1/(1+d)^n	Discount factor @ 14%	1.000	0.877	0.769	0.675	0.592
(Discount factor*FCF)	PV of FCF	(3,990,000)	1,329,824.56	1,166,512.77	1,023,256.82	998,247.35
Sum of all PVs	NPV	527,841.50
Using IRR function	IRR	20.21%

2). Sensitivity analysis:

	NPV	IRR
Sales 50% higher than base case	2,179,916.38	38.44%
Sales 75% higher than base case	3,005,953.82	47.06%
Sales 50% lower than base case	(1,124,233.38)	-0.23%
Sales 75% lower than base case	(1,950,270.81)	-12.04%

3). Break-even equipment price (using excel Solver) when NPV becomes zero = 4,564,877.32

Note: Due to the answer word limit, the NPV tables for part 2 have not been posted.