A company considers purchasing a high-capacity industrial 3-D printer. The manag

Question

A company considers purchasing a high-capacity industrial 3-D printer. The management anticipates that the new machine will lead to more economic use of raw materials, reduced labor costs, and increased sales. The firm estimates that the installation of the machine will save $40,000 on raw materials and $50,000 on reduced labor costs and will increase sales by $60,000 (all estimates are per year).
The proposed machine costs $500,000 and it will have a five year anticipated life and will be depreciated using MACRS depreciation method toward a zero salvage value (MACRS depreciation rates are given below). However, the company will be able to sell the machine in the after-market for 20% of its original costs at the end of year 5. The company requires a 11% rate of return from its investment and faces a 35% tax rate (the company is profitable).
a) Calculate the NPV and IRR for the project. Should the company invest in this machine?

The manager raised some concerns about increased revenues. She projects that the increased revenues could be 10% to 50% less than what was projected. However, the savings from reduced labor costs and reduced raw material costs would remain same. She presented the probability distribution on the projected sales (see the table below).
b) Estimate the NPV and IRR for each of these scenarios.
c) Estimate the expected NPV, which is equal the weighted average sum of NPVs under each scenario weighted (multiplied) by the probability of a given scenario. Should the company invest in the machine under this revised analysis?
d) At what increased sales volume, the company would have a break-even (NPV=0)?

Explanation / Answer

Investment versus financing A key concept of business finance requires separating the investment decision from the financing decision. The liabilities and net worth comprise the source of funds—where the company gets its money. The assets represent how those funds are invested—the investment decision. The key point is that it does not matter what the source of funds is when evaluating an investment. For example, suppose an airline wanted to acquire an airplane for a new route. The investment project is the new route. The airplane and crew, ground personnel, fuel, ticketing, airport fees, and so on represent the costs, or cash outflows, of this project. The revenues from ticket sales are the revenues or cash inflows of the project. These aspects of the project will remain the same regardless of how the airline finances the project. The cost of the airplane is considered a cash outflow. The firm could pay for the airplane with cash raised by selling other assets, by using available cash, by borrowing from a bank, issuing bonds, or issuing more stock. Even a lease represents a form of financing. It does not matter what the source of funds is when evaluating an investment. So how does the firm take financing costs into account? Firms use the cost of capital. Cost of capital The cost of capital reflects the minimum amount that a firm must earn on its assets in order for those assets to add value to the firm. Expressed as a percent, the cost of capital is the rate at which assets must provide cash inflows to justify their cost. Therefore, if the rate of return of the net cash flows from a project, including the initial investment and all future net cash flows, exceeds the cost of capital, the project will add to the value of the firm. This was the case in Challenge B. There you found that the assets generated a return of 21.31 percent, while the cost of capital was assumed to be 15 percent. Understanding the derivation of the cost of capital requires a review of how equity markets work, which goes beyond the scope of this course. For the purpose of this topic, assume that the company's financial manager has derived a value for the cost of capital to use in evaluating projects. Value additivity Value additivity is the concept that the present value of a company equals the sum of the present value of independent projects. For projects to be evaluated independently, the cash flows from new projects must include the effects that new projects have on existing projects. This simple concept compels financial managers to go back and reevaluate existing projects and helps managers focus on all of the relevant cash flows attributable to the new project. Relevant cash flows Constructing the relevant cash flows for project evaluation is important and sometimes difficult. Some financial instruments, such as bonds and mortgages, present a fairly well-defined set of cash flows. Other financial instruments, such as options, futures, and derivatives, can have complex cash flows dependent on several factors. Most business projects require as much art as science in projecting the cash inflows and cash outflows of a project, including the effects of proposals on existing undertakings. More advanced courses will deal with computing the cost of capital projects and relevant cash flows of the firm's projects. The remainder of this section will consider two methods analysts use to evaluate the cash flows of different projects, regardless of when those cash flows occur. These two methods are the net present value (NPV) and the internal rate of return (IRR). Does using returnable containers save a company money? Read about how to evaluate this option using net present value. Can You Justify Returnables? Projects with a Positive NPV Add Value to the Firm The net present value, or NPV, is one of the most common methods used to evaluate investments. At its simplest, NPV is the present value computed by using the firm's cost of capital as the discount rate of cash inflows, minus the present value of cash outflows, including the initial investment. Cash inflows and outflows can occur at any time during the project. The NPV of the project is the sum of the present values of the net cash flows for each time period t, where t takes on the values 0 (the beginning of the project) through N (the end of the project). How does an entrepreneur use net present value? Low bandwith High bandwith This can be expressed as Sometimes, for convenience, this can be written with the initial cash flow listed separately as C0 is negative if there is an initial cash outflow. Analytical Methods: Summation If the present value of the cash flows, discounted at the cost of capital, exceeds the cost of the investment, then the investment will add to the value of the company. The positive NPVs calculated in Challenges B and C, where the discount rates equaled the costs of capital, indicated that those projects would add value to the firm.

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