Superior Manufacturers is considering a 3-year project with an initial cost of $
ID: 2737348 • Letter: S
Question
Superior Manufacturers is considering a 3-year project with an initial cost of $846,000. The project will not directly produce any sales but will reduce operating costs by $295,000 a year. The equipment is depreciated straight-line to a zero book value over the life of the project. At the end of the project the equipment will be sold for an estimated $30,000. The tax rate is 34 percent. The project will require $31,000 in extra inventory for spare parts and accessories. Should this project be implemented if Superior Manufacturing requires an 8 percent rate of return? Why or why not? According to my professor the correct answer is No, The NPV is -87,820.48.
Explanation / Answer
Answer:
Calculation of total Initial Cost
Initial Cost of project
$846,000
Add: Working Capital requirement
(Extra inventory for spare parts)
$31,000
Total Initial Cost
$877,000
Present Value of Cost saving in operating costs
Annual reduction in operating cost (Cost saving)
$295,000
Less: Depreciation ($846,000 / 3)
($282,000)
Net Annual Saving
$13,000
Less: Tax @ 34%
($4,420)
After tax net saving
$8,580
Add: Depreciation (non cash item)
$282,000
Cash Flow
$290,580
PVIFA (8%, 3)
2.577
Present Value of Cash Flow (290,580*2.577)
748,824.66
Add: Present Value of Working Capital Released (31,000*0.794)
$24,614
Add: Present Value of sale proceed of equipment at the end of life of project ($30,000*(1 – 0.34)*0.794)
$15,721.20
Present Value of Cash Flow
789,159.86
Net Present Value = PV of Cash Flow – Total Initial Cost
= $789,159.86 - $877,000
= - $87,840.14
There may be difference of PVIF rounding off..
Since NPV is negative, project should not be accepted.
Initial Cost of project
$846,000
Add: Working Capital requirement
(Extra inventory for spare parts)
$31,000
Total Initial Cost
$877,000
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