Consider a project to supply Detroit with 40,000 tons of machine screws annually

Question

Consider a project to supply Detroit with 40,000 tons of machine screws annually for automobile production. You will need an initial $6,000,000 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 $200 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 $680,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $300 per ton. The engineering department estimates you will need an initial net working capital investment of $580,000. You require a 18 percent return and face a marginal tax rate of 30 percent on this project.

Suppose you

Consider a project to supply Detroit with 40,000 tons of machine screws annually for automobile production. You will need an initial $6,000,000 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 $200 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 $680,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $300 per ton. The engineering department estimates you will need an initial net working capital investment of $580,000. You require a 18 percent return and face a marginal tax rate of 30 percent on this project.

Explanation / Answer

a)

Annual OCF =( (selling price - Variable cost)* Annual Quantity to be sold - fixed cost )*(1-tax rate) + Depreciation * tax rate

Annual OCF = ((300-200)*40000-700000)*(1-30%) + 6000000/6*30%

Annual OCF = $ 2,610,000

b)

NPV = - Initial Investment in equipment -Initial Investment in working Capital + Annual OCF*PVIFA(rate,nper) + Post tax salvage Value*PVIF(rate,nper) + working Capital*PVIF(rate,nper)

NPV = -6000000 - 580000 + 2610000*PVIFA(18%,6) + 680000*(1-30%)*PVIF(18%,6) + 580000*PVIF(18%,6)

NPV = -6000000 - 580000 + 2610000*3.49760256 + 680000*(1-30%)*0.37043154 + 580000*0.37043154

NPV = $ 2,939,918.39

c)

NPV = - Initial Investment in equipment -Initial Investment in working Capital + Minimum OCF*PVIFA(rate,nper) + Post tax salvage Value*PVIF(rate,nper) + working Capital*PVIF(rate,nper)

0 = -6000000 - 580000 + Minimum OCF*PVIFA(18%,6) + 680000*(1-30%)*PVIF(18%,6) + 580000*PVIF(18%,6)

0 = -6000000 - 580000 + Minimum OCF*3.49760256 + 680000*(1-30%)*0.37043154 + 580000*0.37043154

Minimum OCF = 6188824.29/3.49760256

Minimum OCF = $ 1,769,447.55

Annual Minimum OCF =( (selling price - Variable cost)* minimum level of output - fixed cost )*(1-tax rate) + Depreciation * tax rate

1,769,447.55 = ((300-200)*minimum level of output-700000)*(1-30%) + 6000000/6*30%

Minimum level of output =( (1769447.55-6000000/6*30%)/(1-30%) + 700000 )/(300-200)

Minimum level of output = 27,992.11

Minimum level of output = 27,992

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