Drexel Manufacturing (DM) is a leading firm in the creation of environmentally safe containers. DM is considering purchasing new technologically advanced equipment that will not only increase production capabilities but also save the firm money on daily operating expenses. The new investment is estimated to cost $5,250,000. It has a five-year useful life. Given the greater speed of the new equipment, you believe units sold would rise by 500,000 and are estimated to sell at $10 each. It costs $5 per unit to produce. You forecast a savings on operating expenses of $500,000 per year. Start-up net working capital is estimated at $300,000. After five-years, you estimate new technology will be available and believe you can sell the current equipment for $425,000. The current tax rate is 25% and the required rate of return is 8.75%. Calculate the payback period, NPV and IRR

Drexel Manufacturing (DM) is a leading firm in the creation of environmentally safe containers. DM is considering purchasing new technologically advanced equipment that will not only increase production capabilities but also save the firm money on daily operating expenses. The new investment is estimated to cost $5,250,000. It has a five-year useful life. Given the greater speed of the new equipment, you believe units sold would rise by 500,000 and are estimated to sell at $10 each. It costs $5 per unit to produce. You forecast a savings on operating expenses of $500,000 per year. Start-up net working capital is estimated at $300,000. After five-years, you estimate new technology will be available and believe you can sell the current equipment for $425,000. The current tax rate is 25% and the required rate of return is 8.75%. Calculate the payback period, NPV and IRR

Corporate Fin Focused Approach

5th Edition

ISBN:9781285660516

Author:EHRHARDT

Publisher:EHRHARDT

Chapter11: Cash Flow Estimation And Risk Analysis

Section: Chapter Questions

Problem 1iM

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I know that its the thing to do, insisted Pamela Kincaid, vice president of finance for Colgate Manufacturing. If we are going to be competitive, we need to build this completely automated plant. Im not so sure, replied Bill Thomas, CEO of Colgate. The savings from labor reductions and increased productivity are only 4 million per year. The price tag for this factoryand its a small oneis 45 million. That gives a payback period of more than 11 years. Thats a long time to put the companys money at risk. Yeah, but youre overlooking the savings that well get from the increase in quality, interjected John Simpson, production manager. With this system, we can decrease our waste and our rework time significantly. Those savings are worth another million dollars per year. Another million will only cut the payback to about 9 years, retorted Bill. Ron, youre the marketing managerdo you have any insights? Well, there are other factors to consider, such as service quality and market share. I think that increasing our product quality and improving our delivery service will make us a lot more competitive. I know for a fact that two of our competitors have decided against automation. Thatll give us a shot at their customers, provided our product is of higher quality and we can deliver it faster. I estimate that itll increase our net cash benefits by another 2.4 million. Wow! Now thats impressive, Bill exclaimed, nearly convinced. The payback is now getting down to a reasonable level. I agree, said Pamela, but we do need to be sure that its a sound investment. I know that estimates for construction of the facility have gone as high as 48 million. I also know that the expected residual value, after the 20 years of service we expect to get, is 5 million. I think I had better see if this project can cover our 14% cost of capital. Now wait a minute, Pamela, Bill demanded. You know that I usually insist on a 20% rate of return, especially for a project of this magnitude. Required: 1. Compute the NPV of the project by using the original savings and investment figures. Calculate by using discount rates of 14% and 20%. Include salvage value in the computation. 2. Compute the NPV of the project using the additional benefits noted by the production and marketing managers. Also, use the original cost estimate of 45 million. Again, calculate for both possible discount rates. 3. Compute the NPV of the project using all estimates of cash flows, including the possible initial outlay of 48 million. Calculate by using discount rates of 14% and 20%. 4. CONCEPTUAL CONNECTION If you were making the decision, what would you do? Explain.
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