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 $3,600,000 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 $250 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 $250,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $380 per ton. The engineering department estimates you will need an initial net working capital investment of $360,000. You require a return of 16 percent and face a marginal tax rate of 38 percent on this project.

What is the estimated OCF for this project? (Do not round intermediate calculations. Round your answer to the nearest whole number, e.g., 32.)

What is the estimated NPV for this project? (Do not round intermediate calculations. Round your answer to 2 decimal places, e.g., 32.16.)

Suppose you believe that the accounting department’s initial cost and salvage value projections are accurate only to within ±15 percent; the marketing department’s price estimate is accurate only to within ±10 percent; and the engineering department’s net working capital estimate is accurate only to within ±5 percent. What are your worst-case and best-case NPVs for this project? (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Round your answers to 2 decimal places, e.g., 32.16.)

Consider a project to supply Detroit with 20,000 tons of machine screws annually for automobile production. You will need an initial $3,600,000 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 $250 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 $250,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $380 per ton. The engineering department estimates you will need an initial net working capital investment of $360,000. You require a return of 16 percent and face a marginal tax rate of 38 percent on this project.

Explanation / Answer

Ans;

Operating Cash Flow (OCF) is the amount of cash generated in the business through the regular course of operation.

OCF = Earnings before interest and tax (EBIT) + Depreciation Taxes

EBT = Sales (Fixed cost + Variable cost)
        = ($380 20,000) ($850,000 + $250 20,000)
        = $7,600,000 ($850,000 + $5,000,000)
        = $7,600,000 - $5,850,000
        = $1,750,000

Tax = EBT Tax rate = $1,750,000 38% = $665,000

Depreciation under straight line method = (Initial investment Salvage value) Life
                               = ($3,600,000 -$250,000) 4
                               = $837,500

Since the fixed cost is $850,000 and depreciation is $837,500, the interest expense would be $850,000 - $837,500 = $12,500

EBIT = EBT + Interest expense = $1,750,000 + $12,500 = $1,762,500.

Therefore, the required OCF = $1,762,500 + $837,500 - $665,000 = $1,935,000 (Answer).

Net present value (NPV) is the conversion of future cash flows in todays date at return factor, after deducting the initial investment.

Net cash flow = OCF Interest expense = $1,935,000 - $12,500 = $1,922,500

NPV table
Year   Net cash flow (NCF)    Return factor at 16%
                                             1 / (1 + 0.16) ^year   Present value = NCF factor
0   -$3,960,000                             1                           -$3,960,000.00
1   $1,922,500                           0.8621                       $1,657,387.25
2   $1,922,500                           0.7432                       $1,428.802.00
3   $1,922,500                           0.6407                       $1,231,745.75
4   $2,532,500                            0.5523                       $1,398,699.75
NPV                                                                           $1,756,634.75

Working note:
NCF at 0 year = Initial investment + working capital
NCF at 4th year = $1,922,500 + Working capital + Salvage value.

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