NEW PROJECT ANALYSIS Holmes Manufacturing is considering a new machine that costs $250,000 and would reduce pretax manufacturing costs by $90,000 annually. Holmes would use the 3-year MACRS method to depreciate the machine, and management thinks the machine would have a value of $23,000 at the end of its 5-year operating life. The applicable depreciation rates are 33%, 45%, 15%, and 7%, as discussed in Appendix 12A. Net operating working capital would increase by $25,000 initially, but it would be recovered at the end of the project's 5-year life. Holmes's marginal tax rate is 40%, and a 10% WACC is appropriate for the project.
Calculate the project's expected NPV, its standard deviation, and its coefficient of variation. Would you recommend that the project be accepted? Why or why not?
a.
To compute: The NPV, IRR, MIRR and payback of the project.
Introduction:
Net Present Value (NPV):
NPV is the technique of capital budgeting. Selection or rejection of the project is depending on the NPV of the project. If the project has positive NPV, than accept the project. If the NPV is negative, than reject the project.
Internal Rate of Return (IRR):
IRR is a capital budgeting technique that involves the time value of money concept. The IRR percentage gives the idea about the profitability arises from an investment. The IRR of a project is calculated with the help of NPV calculations.
Modified Internal Rate of Return(MIRR):
MIRR is a kind of technique used in capital budgeting while selecting a project. It is modified version of the IRR and commonly used in large-scale business to purchase heavy investment.
Payback period:
It is ascertained when project cost is divided by the annual cash flows of the respective project. The payback period is a method used in capital budgeting. It does not involve the time value of the money factor.
Scenario Analysis:
Under this analysis, the management considers the different alternative outcome to analyze the future events. It is the method in which the analyst estimates the expected future value after a period of time.
Given information:
Cost of machine is $250,000.
Reduction in pretax manufacturing cost is $90,000.
Estimated value after 5 year is $23,000.
Depreciation rate under MACRS method is 33%, 45%, 15%, and 7%.
Net operating working capitalis increased by $25,000.
Tax rate is 40%.
Weighted average cost of capital is 10%.
For NPV
Calculated values (working note),
Present value of cash inflow is $301,446.8.
Present value of cash outflow is $250,000.
Formula to calculate net present value is,
Substitute $301,446.8 for present value of cash inflow and $250,000 for present value of cash outflow.
For IRR
Calculated values (working note),
Present value factors are 10% and 18%.
NPV at 10% is $51,446.8.
NPV at 18% is
Formula to calculate IRR is,
Substitute 10% for lower rate, $51,446.8 for lower rate NPV, -$1,043.4 for higher rate NPV, and 18% for higher rate in the above equation
For MIRR
Year |
Amount ($) |
Future discount Factor at 10% |
Future value ($) |
5 | 87,000 | 1.6105 | 140,113.5 |
4 | 81,000 | 1.4641 | 118,592.1 |
3 | 69,000 | 1.3310 | 91,839 |
2 | 61,000 | 1.2100 | 73,810 |
1 | 99,800 | 1.1000 | 109,780 |
Total | 534,134.6 |
Table (1)
Formula to calculate MIRR,
Substitute $534,134.6 for sum of future cash flow and $397,800 for sum of present values of cash flows.
For payback period,
Formula to calculate the payback period is,
Substitute $250,000 for cost of project, 3 years for years up to which cumulative cash flow are equal to project cost, $237,000 for cumulative cash flows and $69,000 for cash flow of the year.
b.
To compute: NPV where 20% increase in savings and 20% decrease in savings.
c.
To compute: The expected NPV, standard deviation and coefficient of variation.
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