Problem 11-27 Scenario Analysis [LO2] Consider a project to supply Detroit with
ID: 2804715 • Letter: P
Question
Problem 11-27 Scenario Analysis [LO2] Consider a project to supply Detroit with 40,000 tons of machine screws annually for automobile production. You will need an initial $5,000,000 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 $700,000 and that variable costs should be $300 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 $600,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $370 per ton. The engineering department estimates you will need an initial net working capital investment of $500,000. You require a return of 15 percent and face a marginal tax rate of 30 percent on this project. a-1 What is the estimated OCF for this project? (Do not round intermediate calculations. Round your answer to the nearest whole number, e.g., 32.) OCF a-2 What is the estimated NPV for this project? (Do not round intermediate calculations. 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 are your worst-case and best-case NPVs for this project? (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Round your answers to 2 decimal places, e--,32.16.) Worst-case Best-caseExplanation / Answer
Given, fixed cost = 5000,000 and working capital requirement = 500,000
Initial outlay = FCinv + WCinv
= 5000,000+500,000
=5500,000
The asset will depreciate on SLM basis to zero over 6 years
thus depreciation per year = 5000,000 / 6 = 833,333.34
Terminal value = Salvage + WCinv - tax*(salvage-bookvalue)
=600,000+500,000 - 0.30*(600,000-0)
=1100,000 - 180000
=920,000
Answer a-1.
Sales = Price*units = 370*40000 = 14800,000
Variable cost = 300*40000 = 12,000,000
Fixed cost = 700,000
Total cost = 12,000,000+700,000 = 12,700,000
OCF = sales-cost-depreciation*(1-tax) + Depreciation
=(14800,000-12700,000-833,333)*(1-0.30) + 833,333
=1719,999.9
=1720,000
Answer a-2.
NPV at 15% required return is:
Year
Cashflow
0
-5500000
1
1720000
2
1720000
3
1720000
4
1720000
5
1720000
6
2640000
NPV at 15%
$1,223,523.15
Given, the initial cost can be in the range of +-15% thus fixed cost = 5000,000
Hence worst case FCinv = 5000,000*(1-0.15) = 4250,000
Best case FCinv = 5000,000*(1+0.15) = 5750,000
and,
the net working capital can be in the range of +-5% thus working capital = 500,000
Hence worst case WCinv = 500,000*(1-0.05) = 475,000
Best case WCinv = 500,000*(1+0.05) = 525,000
Worst case Initial outlay = FCinv + WCinv
= 4250,000+475000
= 4725000
Best case Initial outlay = FCinv + WCinv
= 5750,000+525,000
= 6275,000
Salvage value is +-15% thus salvage = 600,000
Worst case salvage value = 600,000*(1-0.15) = 510,000
Best case salvage value = 600,000*(1+0.15) = 690,000
Thus worst case terminal cashflow = 510,000+475,000 - 0.38*(510,000-0)
= 985,000 - 193800
= 791,200
Best case terminal cashflow = 690,000+525,000 - 0.38*(690,000-0)
=1215000 - 262,200
=952800
The sales price for can be in the range of +-10%
thus worst case Sales = Price*units = 370*(1-0.10)*40000 = 13320,000
best case sales = Price*units = 370*(1+0.10)*40000 = 16280,000
Variable cost = 200*25000 = 5000,000
Fixed cost = 700,000
Total cost = 12,000,000+700,000 = 12,700,000
Worst case OCF = sales-cost-depreciation*(1-tax) + Depreciation
=(13320,000-12700,000-833,333)*(1-0.30) + 833,333
=684,000
Best case OCF = sales-cost-depreciation*(1-tax) + Depreciation
=(16280,000-12700,000-833,333)*(1-0.30) + 833,333
=2756,000
Best and worst case NPV at 15% is:
Year
Worst case
Best case
0
-4725000
-6275000
1
684000
2756000
2
684000
2756000
3
684000
2756000
4
684000
2756000
5
684000
2756000
6
1475200
3708800
NPV at 15%
-$1,560,309.78
$3,971,266.12
Year
Cashflow
0
-5500000
1
1720000
2
1720000
3
1720000
4
1720000
5
1720000
6
2640000
NPV at 15%
$1,223,523.15
You can also find NPV by inserting respective cashflows in the financial calculator and pressing CPT NPV at 15%