Question

Consider a project to supply Detroit with 28,000 tons of machine screws annually for automobile production. You will need an additional $6,100,000 investment in threading equipment to get the project started; the project will last six years. The accounting department estimates that annual fix cost will be $1,475,000 and the variable cost should be $280 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the 6-year project life. It also estimates a salvage value of $850,000 after dismantling costs. The marketing department estimates that the auto makers will let the contract at a selling price of $398 per ton. The engineering department estimates you will need an initial networking capital investment of $590,000. You require a return of 12% and face a tax rate of 23% on this project. What is the estimated OCF for this project? WHAT IS THE ESTIMATED NPV FOR THIS PROJECT? WHAT ARE THE WORST CASE AND BEST CARE NPVs FOR THIS PROJECT?

Answer 1

The OCF for the project is $2,412,464. The NPV needs to be calculated using discounted cash flows including initial investments and terminal salvage value. Best-case and worst-case NPVs would require adjustment of the variables and recalculation of OCF and NPV.

Step-by-step explanation:

Calculating the project's Operating Cash Flow (OCF) involves considering revenues, costs and taxes. With a selling price of $398 per ton and variable costs of $280 per ton for 28,000 tons, the annual revenue is $11,144,000 (28,000 tons × $398 per ton) and annual variable costs are $7,840,000 (28,000 tons × $280 per ton). The annual depreciation is the initial investment of $6,100,000 spread over the 6-year lifespan, giving $1,016,667 per year. Thus, the annual operating income before tax is the annual revenue minus annual fixed costs of $1,475,000 and variable costs minus depreciation, resulting in $1,812,333. After applying the tax rate of 23%, the after-tax operating income is $1,395,797 (1 - 0.23) × $1,812,333. Adding back the depreciation, the OCF is $2,412,464 ($1,395,797 + $1,016,667).

Next, to determine the Net Present Value (NPV), all cash flows must be considered, including the initial investment in equipment and networking capital, annual OCFs, and the terminal cash flow from the salvage value after taxes. Using a discount rate of 12%, the NPV is calculated by discounting these cash flows back to present value.

The worst-case and best-case NPV scenarios would involve adjusting the assumed variables such as selling price, variable cost, and the salvage value in a conservative and optimistic manner respectively, re-calculating the OCF and consequently the NPV for each.