Concept explainers
Project Analysis You are considering a new product launch. The project will cost $760,000, have a four-year life, and have no salvage value;
- a. Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within ±10 percent. What are the upper and lower bounds for these projections? What is the base-case
NPV ? What are the best-case and worst-case scenarios? - b. Evaluate the sensitivity of your base-case NPV to changes in fixed costs.
- c. What is the accounting break-even level of output for this project?
a)
To determine: Best-case net present value.
Introduction:
The difference between the present value of cash outflow and the present value of cash inflow is termed as net present value.
Explanation of Solution
Given information:
The project has the cost of $760,000 with no salvage value and 4 years of economic cycle. Depreciation is on straight line method. The sales are at 420 units, the price per unit is $17,200, the variable cost per unit is $14,300, and the fixed cost is$640,000 per year. The required rate of return is 15% and the rate of tax is35%.
The variable cost, unit price, fixed cost projections are accurate within ±10%.
The formula to calculate the net present value:
The formula to calculate the operating cash flow:
Compute the upper and lower bounds of the above projections:
In the best-case, when the cost decreases, the unit sales will increase; whereas in the worst-case, when the cost increases, the unit sales will decrease.
Scenario |
Base case | Upper case | Lower case |
Unit sales | 420 | 462 | 378 |
Variable costs | $14,300 | $12,870 | $15,730 |
Fixed costs | $640,000 | $576,000 | $704,000 |
Note: Refer excel for the above table.
Compute the base-case operating cash flow:
Hence, the base-case operating cash flow is$442,200.
Compute the base-case net present value:
Note: The increase in the operating cash flow at the present value interest factor of annuity at 15% for 4 years is 2.85498.
Compute the base-case net present value:
Hence, the base-case net present value is$502,472.15.
Compute the worst–case operating cash flow:
Hence, the worst-case operating cash flow is−$29,921.
Compute the worse-case net present value:
Note: The increase in the operating cash flow at the present value interest factor of annuity at 15% for 4 years is 2.85498.
Hence, the worse-case net present value is −$845,423.85.
Compute the best-case operating cash flow:
Hence, the best-case operating cash flow is $992,399.
Compute the best-case net present value:
Hence, the best-case net present value is $2,073,279.29.
b)
To determine: The sensitivity of base-case net present value to the changes in fixed costs.
Answer to Problem 13QP
Solution: Therefore, the net present value falls by −$1.856 for an increase in every dollar.
Explanation of Solution
Given information:
The project has the cost of $760,000 with no salvage value and 4 years of economic cycle. Depreciation is on straight line method. The sales are at 420 units, the price per unit is $17,200, the variable cost per unit is $14,300, and the fixed cost is $640,000 per year. The required rate of return is 15% and the rate of tax is 35%.
Compute the base-case operating cash flow to the changes in fixed costs:
Note: To compute the sensitivity of base-case net present value to the changes in fixed costs, the levels of fixed cost need to increase to another level. Assume it to be $650,000.
Hence, the base-caseoperating cash flow is $435,700.
Compute the base-case net present value:
Hence, the base-case net present value is $483,914.78.
Compute the sensitivity of net present value to the changes in fixed costs:
Hence, the sensitivity of net present value to the changes in fixed cost is −$1.856.
Therefore, the net present value falls by −$1.856for an increase in every dollar.
c)
To determine: The accounting break-even level of output.
Introduction:
Accounting break-even point refers to a point where the company faces zero profits.
Answer to Problem 13QP
Solution: The accounting break-even point is 286.21 units.
Explanation of Solution
Given information:
The project has a cost of $760,000 with no salvage value and 4 years of economic cycle. Depreciation is on straight line method. The sales are at 420 units, the price per unit is $17,200, the variable cost per unit is $14,300, and the fixed cost is $640,000 per year. The required rate of return is 15% and the rate of tax is 35%.
The variable cost, unit price, fixed cost projections are accurate within ±10%.
The formula to calculate the accounting break-even level:
Compute the accounting break-even level:
Hence, the accounting break-even point is286.21 units.
Want to see more full solutions like this?
Chapter 7 Solutions
GEN CMB LL CORP FINC; CNCT
- Friedman Company is considering installing a new IT system. The cost of the new system is estimated to be 2,250,000, but it would produce after-tax savings of 450,000 per year in labor costs. The estimated life of the new system is 10 years, with no salvage value expected. Intrigued by the possibility of saving 450,000 per year and having a more reliable information system, the president of Friedman has asked for an analysis of the projects economic viability. All capital projects are required to earn at least the firms cost of capital, which is 12 percent. Required: 1. Calculate the projects internal rate of return. Should the company acquire the new IT system? 2. Suppose that savings are less than claimed. Calculate the minimum annual cash savings that must be realized for the project to earn a rate equal to the firms cost of capital. Comment on the safety margin that exists, if any. 3. Suppose that the life of the IT system is overestimated by two years. Repeat Requirements 1 and 2 under this assumption. Comment on the usefulness of this information.arrow_forwardREPLACEMENT ANALYSIS St. Johns River Shipyards is considering the replacement of an 8-year-old riveting machine with a new one that will increase earnings from 24,000 to 46,000 per year. The new machine will cost 80,000, and it will have an estimated life of 8 years and no salvage value. The new riveting machine is eligible for 100% bonus depreciation at the time of purchase. The applicable corporate tax rate is 25%, and the firms WACC is 10%. The old machine has been fully depreciated and has no salvage value. Should the old riveting machine be replaced by the new one? Explain your answer.arrow_forwardNew-Project Analysis The Campbell Company is considering adding a robotic paint sprayer to its production line. The sprayer’s base price is $1,080,000, and it would cost another $22,500 to install it. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $605,000. The MACRS rates for the first 3 years are 0.3333, 0.4445, and 0.1481. The machine would require an increase in net working capital (inventory) of $15,500. The sprayer would not change revenues, but it is expected to save the firm $380,000 per year in before-tax operating costs, mainly labor. Campbell’s marginal tax rate is 35%. What is the Year-0 cash flow? What are the net operating cash flows in Years 1, 2, and 3? What is the additional Year-3 cash flow (i.e., the after-tax salvage and the return of working capital)? If the project’s cost of capital is 12%, should the machine be purchased?arrow_forward
- The Rodriguez Company is considering an average-risk investment in a mineral water spring project that has an initial after-tax cost of 170,000. The project will produce 1,000 cases of mineral water per year indefinitely, starting at Year 1. The Year-1 sales price will be 138 per case, and the Year-1 cost per case will be 105. The firm is taxed at a rate of 25%. Both prices and costs are expected to rise after Year 1 at a rate of 6% per year due to inflation. The firm uses only equity, and it has a cost of capital of 15%. Assume that cash flows consist only of after-tax profits because the spring has an indefinite life and will not be depreciated. a. What is the present value of future cash flows? (Hint: The project is a growing perpetuity, so you must use the constant growth formula to find its NPV.) What is the NPV? b. Suppose that the company had forgotten to include future inflation. What would they have incorrectly calculated as the projects NPV?arrow_forwardGina Ripley, president of Dearing Company, is considering the purchase of a computer-aided manufacturing system. The annual net cash benefits and savings associated with the system are described as follows: The system will cost 9,000,000 and last 10 years. The companys cost of capital is 12 percent. Required: 1. Calculate the payback period for the system. Assume that the company has a policy of only accepting projects with a payback of five years or less. Would the system be acquired? 2. Calculate the NPV and IRR for the project. Should the system be purchasedeven if it does not meet the payback criterion? 3. The project manager reviewed the projected cash flows and pointed out that two items had been missed. First, the system would have a salvage value, net of any tax effects, of 1,000,000 at the end of 10 years. Second, the increased quality and delivery performance would allow the company to increase its market share by 20 percent. This would produce an additional annual net benefit of 300,000. Recalculate the payback period, NPV, and IRR given this new information. (For the IRR computation, initially ignore salvage value.) Does the decision change? Suppose that the salvage value is only half what is projected. Does this make a difference in the outcome? Does salvage value have any real bearing on the companys decision?arrow_forwardTalbot Industries is considering launching a new product. The new manufacturing equipment will cost $17 million, and production and sales will require an initial $5 million investment in net operating working capital. The company’s tax rate is 25%. What is the initial investment outlay? The company spent and expensed $150,000 on research related to the new product last year. What is the initial investment outlay? Rather than build a new manufacturing facility, the company plans to install the equipment in a building it owns but is not now using. The building could be sold for $1.5 million after taxes and real estate commissions. What is the initial investment outlay?arrow_forward
- EBK CONTEMPORARY FINANCIAL MANAGEMENTFinanceISBN:9781337514835Author:MOYERPublisher:CENGAGE LEARNING - CONSIGNMENTCornerstones of Cost Management (Cornerstones Ser...AccountingISBN:9781305970663Author:Don R. Hansen, Maryanne M. MowenPublisher:Cengage LearningIntermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning
- Fundamentals Of Financial Management, Concise Edi...FinanceISBN:9781337902571Author:Eugene F. Brigham, Joel F. HoustonPublisher:Cengage LearningSurvey of Accounting (Accounting I)AccountingISBN:9781305961883Author:Carl WarrenPublisher:Cengage LearningManagerial AccountingAccountingISBN:9781337912020Author:Carl Warren, Ph.d. Cma William B. TaylerPublisher:South-Western College Pub