Consider a project to supply Detroit with 20,000 tons of machine screws annually

Question

Consider a project to supply Detroit with 20,000 tons of machine screws annually for automobile production. You will need an initial $3,000,000 investment in threading equipment to get the project started; the project will last for four 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 four-year project life. It also estimates a salvage value of $280,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $600 per ton. The engineering department estimates you will need an initial net working capital investment of $300,000. You require a 18 percent return and face a marginal tax rate of 38 percent on this project.

Suppose you

Consider a project to supply Detroit with 20,000 tons of machine screws annually for automobile production. You will need an initial $3,000,000 investment in threading equipment to get the project started; the project will last for four 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 four-year project life. It also estimates a salvage value of $280,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $600 per ton. The engineering department estimates you will need an initial net working capital investment of $300,000. You require a 18 percent return and face a marginal tax rate of 38 percent on this project.

Explanation / Answer

First, I use the tax shield approach to calculate OCF:

OCF = (Sales - Cost)(1 - tax rate) + (tax rate x Depreciation)
OCF = (5.2 mil - 2.15 mil)(.70) + [.30 x (6.0 mil / 3)]
OCF = 2,135,000 + 600,000
OCF = 2,735,000

Now, I can solve for NPV using the calculated OCF and
PVIFAr,t

NPV = (OCF x PVIFAr,t) - initial investment
or NPV = OCF x [1 - 1 / (1+r)^t / r] - initial investment

NPV = (2,735,000 x 2.209582) - 6,000,000
NPV = 43, 206.77

Since this project yields a positive NPV, you should accept it.

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.