We are evaluating a project that costs $805,000, has an seven-year life, and has

Question

We are evaluating a project that costs $805,000, has an seven-year life, and has no salvage value. Assume that depreciation is straight-line to zero over the life of the project. Sales are projected at 89,000 units per year. Price per unit is $38, variable cost per unit is $21, and fixed costs are $820,295 per year. The tax rate is 34 percent, and we require a 18 percent return on this project. The projections given for price, quantity, variable costs, and fixed costs are all accurate to within +/- 20 percent. Calculate the best-case and worst-case NPV.

Explanation / Answer

Ans:

Fixed cost is inclusive of depreciation and estimating error will not impact the depreciation since project cost is known.

Best Case NPV This will happen, when the project register an increase in Units sold by 20%, increase in sales price by 20% ,reduction in variable cost by 20% and reduction in Fixed cost by 20% Detail Detail Change With change Sales in units 89000 20% increase $1,06,800.00 Sales price per unit 38 20% increase $45.60 Variable Cost per unit 21 20% reduction $16.80 Contribution per unit $28.80 Contribution in value Sales in units * Conrtibution per unit $30,75,840.00 Fixed Cost exclusive of depreciation 705295 20% reduction $5,64,236.00 Depreciation         1,15,000.00 $1,15,000.00 Operating Profit per Year $23,96,604.00 Income tax 34% on Opetrating Profit $8,14,845.36 Profit After Tax $15,81,758.64 Add: Depreciation $1,15,000.00 Operating Cash flow $16,96,758.64 Operating Cash inflows for 7 years $64,67,242.38 Initial Cash Outflow $8,05,000.00 Net Present Value $56,62,242.38 Assumption Depreciation is on Full Project cost of 805,000. ie 805000/7

Fixed cost is inclusive of depreciation and estimating error will not impact the depreciation since project cost is known.

Worst case NPV This will happen, when the project register an reduction in Units sold by 20%, reduction in sales price by 20% ,increase in variable cost by 20% and increase in Fixed cost by 20% Detail Detail Change With change Sales in units 89000 20% reduction $71,200.00 Sales price per unit 38 20% reduction $30.40 Variable Cost per unit 21 20% increase $25.20 Contribution per unit $5.20 Contribution in value Sales in units * Conrtibution per unit $3,70,240.00 Fixed Cost exclusive of depreciation 705295 20% increase $8,46,354.00 Depreciation         1,15,000.00 $1,15,000.00 Operating Loss per Year -$5,91,114.00 Income tax 34% on Opetrating Profit $0.00 Loss After Tax -$5,91,114.00 Add: Depreciation $1,15,000.00 Operating Cash outfflow -$4,76,114.00 Operating Cash inflows for 7 years -$18,14,721.65 Initial Cash Outflow $8,05,000.00 Net Present Value -$26,19,721.65 Assumption Depreciation is on Full Project cost of 805,000. ie 805000/7 Fixed cost is inclusive of depreciation and estimating error will not impact the depreciation since project cost is known.

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