NPV; PI; sensitivity analysis Westside Warehouse is considering reengineering so

Question

NPV; PI; sensitivity analysis

Westside Warehouse is considering reengineering some production operations with automated equipment. The new equipment would have an initial cost of $5,000,000 including installation. The vendor has indicated that the equipment has an expected life of seven years with an estimated salvage value of $400,000. Estimates of annual labor savings and incremental costs associated with operating the new equipment follow.

a. Assuming the company’s cost of capital is 6 percent, compute the NPV of the automated equipment. (Ignore taxes.) Round interim calculations and your final answer to the nearest dollar. If the NPV is negative, enter your answer as a negative amount.
$

b. Compute the profitability index for this potential investment. (Ignore taxes.) Round your answer to two decimal places.

c. Assume Westside’s managers are least confident of the estimates of labor cost savings. Calculate the minimum annual labor savings that must be realized for the project to be financially acceptable. Round interim calculations and your final answer to the nearest dollar.
$

Explanation / Answer

a.

Labor Cost savings                                                                           =             950,000

Less: Cost to be incurred(40,000+28,000+44,000) =             (112,000)

Net Annual savings                                                                         =             838,000

Present value of annual savings for 7 years @ 6%              =             5.5824 x 838,000

=             4,678,051

Present value of salvage value at end of year 7                  =             0.6651 x 400,000

                                                                                       =             266,040

Cash Outflow                                                                                     =             5,000,000

PV of Cash Inflow (4,678,051 + 266,040) =             4,944,091

Net Present Value =             (55,909)

b.                           

Profitability Index =             PV of future Cash Flows/Initial Investment

                                                =             4,944,091/5,000,000

                                                =             0.989

c.NPV to be zero

PV of Cash Inflow has to be         =             5,000,000-266,040

=             4,733,960

Net Annual Savings should be    =             4,733,960/5.5824

=             848,015

Therefore, minimum annual labor savings should be       =             848,015+112,000

=             960,015

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