Question

Consider a project to supply Detroit with 40,000 tons of machine screws annually for automobile production. You will need an initial $4,800,000 investment in threading equipment to get the project started; the project will last for three years. The accounting department estimates that annual fixed costs will be $850,000 and that variable costs should be $250 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the three-year project life. It also estimates a salvage value of $460,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $330 per ton. The engineering department estimates you will need an initial net working capital investment of $480,000. You require a return of 10 percent and face a marginal tax rate of 38 percent on this project. What is the estimated OCF for this project? What is the estimated NPV for this project?   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?

Answer 1

Detroit	0	1	2	3
Investment	-$4,800,000
NWC	-$480,000			$480,000
Salvage				$460,000
Sales		$13,200,000	$13,200,000	$13,200,000
VC		-$10,000,000	-$10,000,000	-$10,000,000
FC		-$850,000	-$850,000	-$850,000
Depreciation		-$1,600,000	-$1,600,000	-$1,600,000
EBT		$750,000	$750,000	$750,000
Tax (38%)		-$285,000	-$285,000	-$285,000
Net Income		$465,000	$465,000	$465,000
Cash Flows	-$5,280,000	$2,065,000	$2,065,000	$2,830,200
NPV	$430,255.45

Estimated OCF = Net Income + Depreciation = 2,065,000

NPV = $430,255.45 using 10% discount rate and NPV function

Best case NPV is when initial cost and working capital is lower while salvage value and price is higher.

Detroit	0	1	2	3
Investment	-$4,080,000
NWC	-$456,000			$456,000
Salvage				$529,000
Sales		$14,520,000	$14,520,000	$14,520,000
VC		-$10,000,000	-$10,000,000	-$10,000,000
FC		-$850,000	-$850,000	-$850,000
Depreciation		-$1,360,000	-$1,360,000	-$1,360,000
EBT		$2,310,000	$2,310,000	$2,310,000
Tax (38%)		-$877,800	-$877,800	-$877,800
Net Income		$1,432,200	$1,432,200	$1,432,200
Cash Flows	-$4,536,000	$2,792,200	$2,792,200	$3,576,180
NPV	$2,996,803.91

Worst case NPV is when initial cost and working capital is higher while salvage value and price are lower.

Detroit	0	1	2	3
Investment	-$4,080,000
NWC	-$504,000			$504,000
Salvage				$391,000
Sales		$11,880,000	$11,880,000	$11,880,000
VC		-$10,000,000	-$10,000,000	-$10,000,000
FC		-$850,000	-$850,000	-$850,000
Depreciation		-$1,360,000	-$1,360,000	-$1,360,000
EBT		-$330,000	-$330,000	-$330,000
Tax (38%)		$125,400	$125,400	$125,400
Net Income		-$204,600	-$204,600	-$204,600
Cash Flows	-$4,584,000	$1,155,400	$1,155,400	$1,901,820
NPV	-$1,149,894.82