Question

Consider a project to supply Detroit with 30,000 tons of machine screws annually for automobile production. You will need an initial $4.3 million investment in threading equipment to get the project started; the project will last for five years. The accounting department estimates that annual fixed costs will be $1.025 million and that variable costs should be $190 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the five-year project life. It also estimates a salvage value of $400,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $290 per ton. The engineering department estimates you will need an initial net working capital investment of $410,000. You require a return of 13 percent and face a tax rate of 22 percent on this project.

a-1.	What is the estimated OCF for this project? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
a-2.	What is the estimated NPV for this project? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
b.	Suppose you believe that the accounting department’s initial cost and salvage value projections are accurate only to within ±15 percent; the marketing department’s price estimate is accurate only to within ±10 percent; and the engineering department’s net working capital estimate is accurate only to within ±5 percent. What is your worst-case and best-case scenario for this project? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

Answer 1

All financials below are in $

a - 1

OCF = NOPAT + Depreciation

Depreciation = 4,300,000 / 5 =  860,000

NOPAT = [(Sale price - variable cost) x Nos.of units - fixed costs - depreciation] x (1 - tax rate) = [(290 - 190) x 30,000 - 1,025,000 - 860,000] x (1 - 22%) = 869,700

Hence, OCF given by C = 869,700 + 860,000 = $ 1,729,700

a - 2

Initial investment, C₀ = Purchase cost + initial working capital = 4,300,000 + 410,000 = 4,710,000

Terminal cash flows, C_T = Post tax salvage value + release of working capital = 400,000 x (1 - 22%) + 410,000 =  722,000

Number of years, N = 5 years, Discount rate = R = 13%

Hence, NPV = - C₀ + C / R x [1 - (1 + R)^-N] + C_T x (1 + R)^-N = - 4,710,000 + 4,069,700 / 13% x [1 - (1 + 13%)^-5] + 722,000 x (1 + 13%)^-5 =   1,765,627.59

a - 3

Best case

Initial investment, C₀ = Purchase cost + initial working capital = 4,300,000 x (1 - 15%) + 410,000 x (1 - 5%) = 4,044,500

Terminal cash flows, C_T = Post tax salvage value + release of working capital = 400,000 x (1 + 15%) x (1 - 22%) + 410,000 x (1 - 5%) =   748,300

OCF = NOPAT + Depreciation

Depreciation = 4,300,000 x (1 - 15%) / 5 = 731,000

NOPAT = [(Sale price - variable cost) x Nos.of units - fixed costs - depreciation] x (1 - tax rate) = [(290 x (1 + 10%) - 190) x 30,000 - 1,025,000 - 731,000] x (1 - 22%) = 1,648,920

Hence, OCF given by C = 1,648,920 + 731,000 = 2,379,920

Hence, Best case NPV = - 4,044,500 + 2,379,920 / 13% x [1 - (1 + 13%)^-5] + 748,300 x (1 + 13%)^-5 = 4,732,376.28

Worst case scenario:

Initial investment, C₀ = Purchase cost + initial working capital = 4,300,000 x (1 + 15%) + 410,000 x (1 + 5%) =   5,375,500

Terminal cash flows, C_T = Post tax salvage value + release of working capital = 400,000 x (1 - 15%) x (1 - 22%) + 410,000 x (1 + 5%) =   695,700

OCF = NOPAT + Depreciation

Depreciation = 4,300,000 x (1 + 15%) / 5 = 989,000

NOPAT = [(Sale price - variable cost) x Nos.of units - fixed costs - depreciation] x (1 - tax rate) = [(290 x (1 - 10%) - 190) x 30,000 - 1,025,000 - 989,000] x (1 - 22%) = 90,480

Hence, OCF given by C = 90,480 + 989,000 = 1,079,480

Hence, Worst case NPV = - 5,375,500 + 1,079,480  / 13% x [1 - (1 + 13%)^-5] + 695,700 x (1 + 13%)^-5 = - 1,201,121.11