NEW PROJECT ANALYSIS You must analyze a potential new product—a caulking compound that Cory Materials' R&D people developed for use in the residential construction industry. Cory's marketing manager thinks the company can sell 115,000 tubes per year at a price of $3.25 each for 3 years, after which the product will be obsolete. The required equipment would cost $150,000, plus another $25,000 for shipping and installation. Current assets (receivables and inventories) would increase by $35,000, while current liabilities (accounts payable and accruals) would rise by $15,000. Variable cost per unit is $1.95, fixed costs (exclusive of depreciation) would be $70,000 per year, and fixed assets would be depreciated under MACRS with a 3-year life. (Refer to Appendix 12A for MACRS depreciation rates.) When production ceases after 3 years, the equipment should have a market value of $15,000. Cory's tax rate is 40%, and it uses a 10% WACC for average-risk projects.
a.
To compute: The investment required in year 0, NPV, IRR, MIRR and payback of the project.
Introduction:
Net Present Value (NPV):
NPV is the technique of capital budgeting. To select the project or not is dependent 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):
It is also 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 the cost of the project 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 money factor.
Scenario Analysis:
Under this analysis, the management considers the different alternatives 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 the machine is $150,000.
Installation cost is $25,000.
Estimated value after 3 years is $15,000.
Depreciation rate under MACRS method is 33%, 45%, 15%, and 7%.
Increase in the current asset is $35,000.
Increase in current liability is $15,000.
Net operating working capital is increased by $20,000.
The tax rate is 40%.
Weighted average cost of capital is 10%.
Formula to calculate initial investment:
Substitute $150,000 for cost of machine, $25,000 for installation cost and $20,000 for increase in net working capital,
Here, the investment required in year 0 is $195,000.
For NPV
Calculated values (working note),
The present value of cash inflow is $198,943.5.
The present value of cash outflow is $195,000.
Formula to calculate net present value is:
Substitute $198,943.5 for the present value of cash inflow and $195,000 for the present value of cash outflow,
For IRR
Calculated values (working note):
Present value factors are 10%.
NPV at 10% is $3,943.5.
Calculate IRR,
Table (1)
For MIRR,
Year |
Amount ($) |
Future discount Factor at 10% |
Future value ($) |
3 | 92,100 | 1.3310 | 122,585.1 |
2 | 79,200 | 1.2100 | 95,832 |
1 | 70,800 | 1.1000 | 77,880 |
Total | 296,297.1 |
Table (2)
The formula to calculate MIRR:
Substitute $291,376.8 for sum of future cash flow and $242,100 for the sum of present values of cash flows,
For payback period,
The formula to calculate the payback period:
Substitute $124,200 for the cost of the project, 2 years for years up to which cumulative cash flow is equal to project cost, $79,200 for cumulative cash flows and $92,100 for the cash flow of the year,
b.
To compute: NPV where R & D cost is $30,000.
c.
To identify: The effect of other factors on NPV of the project.
d.
To identify: The correlation of one project with other projects and whether it affects the analysis.
e.
To identify: The NPV, IRR, and MIRR of the project in a spreadsheet.
f.
To prepare: The sensitivity graph.
g.
To identify: The expected NPV, the standard deviation of NPV and coefficient of variation.
h.
To identify: Whether the management uses the risk-adjusted discount rate to adjust for project risk.
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