Chapter 12, Problem 14P

### Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

Chapter
Section

### Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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# 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. a. Calculate the project's NPV, IRR, MIRR, and payback. b. Assume management is unsure about the $90,000 cost savings—this figure could deviate by as much as plus or minus 20%. What would the NPV be under each of these situations? c. Suppose the CFO wants you to do a scenario analysis with different values for the cost savings, the machine's salvage value, and the net operating working capital (NOWC) requirement. She asks you to use the following probabilities and values in the scenario analysis: 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. Summary Introduction 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. Explanation 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, Net present value= Present value of cash inflowPresent value of cash outflow Substitute$301,446.8 for present value of cash inflow and $250,000 for present value of cash outflow. Net present value=$301,446.8$250,000=$51,446.8

For IRR

Calculated values (working note),

Present value factors are 10% and 18%.

NPV at 10% is $51,446.8. NPV at 18% is$1,043.4 .

Formula to calculate IRR is,

IRR=[Lower rate+(Lower rate NPVLower rate NPVHigher rate NPV)×(Higher rateLower rate)]

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

IRR=10%+(51,446.8$51,446.8($1,043.4))×(18%10%)=10%+(51,446.8$52,490.2)×8%=10%+7.84%=17.84% For MIRR  Year Amount ($) 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, MIRR=Sum of Future value of cash flowsSum of present values of cash flows1 Substitute$534,134.6 for sum of future cash flow and $397,800 for sum of present values of cash flows. MIRR=$534,134.6$397,8001=1.34271=1.15881=0.1588 or 15.88% For payback period, Formula to calculate the payback period is, Payback Period=[Year upto which cummulative cash flow are equal to project cost+(Cost of projectCummulative cash flowsCash flow of the year)] 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.

Payback period=3years+($250,000$237,000)$69,000=3years+$13,000\$69,000=3years+0.19=3

b.

Summary Introduction

To compute: NPV where 20% increase in savings and 20% decrease in savings.

c.

Summary Introduction

To compute: The expected NPV, standard deviation and coefficient of variation.

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