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 $5,400,000 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 $850,000 and that variable costs should be $450 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 $380,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $560 per ton. The engineering department estimates you will need an initial net working capital investment of $540,000. You require a 12 percent return and face a marginal tax rate of 38 percent on this project.

Suppose you’re confident about your own projections, but you’re a little unsure about Detroit’s actual machine screw requirement. What is the sensitivity of the project OCF to changes in the quantity supplied? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

What is the sensitivity of NPV to changes in quantity supplied? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Given the sensitivity number you calculated, what is the minimum level of output below which you wouldn’t want to operate? (Do not round intermediate calculations and round your final answer to the nearest whole number.)

Consider a project to supply Detroit with 40,000 tons of machine screws annually for automobile production. You will need an initial $5,400,000 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 $850,000 and that variable costs should be $450 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 $380,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $560 per ton. The engineering department estimates you will need an initial net working capital investment of $540,000. You require a 12 percent return and face a marginal tax rate of 38 percent on this project.

Explanation / Answer

A ) OCF =((560-450)*(40000)-850000)*(1-0.38)+(0.38)*5400000/6           = 2543000

To calculate the sensitivity to changes in quantity sold, we will choose a quantity of 45000

The OCF at this level of sale is:

OCF =((560-450)*(45000)-850000)*(1-0.38)+(0.38)*5400000/6

OCF = $2884000

The sensitivity of changes in the OCF to quantity sold is:

= ($2884000 – 2543000)/(45000 – 40,000)

= +$68.2

b)

NPV=-5400000-540000+2543000*4.1114 +(540000+380000*(1.38)/1.12^6)

NPV = $5320968

The NPV at this level of sales is: (45000 quantity)

NPV=-5400000-540000+2884000*4.1114 +(540000+380000*(1.38)/1.12^6)

NPV = $6722955

And the sensitivity of NPV to changes in the quantity sold is:

= ($6722955 –5320968)/(45000 – 40,000)

= +$280.39

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