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.

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

Answer 1

Time line		0	1	2	3	4
Cost of new machine		-4564877.323
Initial working capital		-170000
=Initial Investment outlay		-4734877.323
Sales			2520000	2520000	2520000	2520000
Profits	Sales-variable cost		1890000	1890000	1890000	1890000
-Depreciation	Cost of equipment/no. of years		-1141219.33	-1141219.331	-1141219.331	-1141219
=Pretax cash flows			748780.6693	748780.6693	748780.6693	748780.67
-taxes	=(Pretax cash flows)*(1-tax)		449268.4016	449268.4016	449268.4016	449268.4
+Depreciation			1141219.331	1141219.331	1141219.331	1141219.3
=after tax operating cash flow			1590487.732	1590487.732	1590487.732	1590487.7
reversal of working capital						170000
+Tax shield on salvage book value	=Salvage value * tax rate					0
=Terminal year after tax cash flows						170000
Total Cash flow for the period		-4734877.323	1590487.73	1590487.7323	1590487.73	1760487.7
Discount factor=	(1+discount rate)^corresponding period	1	1.14	1.2996	1.481544	1.6889602
Discounted CF=	Cashflow/discount factor	-4734877.323	1395164.677	1223828.664	1073533.916	1042350.1
NPV=	Sum of discounted CF=	0

Therefore breakeven cost of machine = 4564877.323