Holmes Manufacturing is considering a new machine that costs $210, 000 and would

Question

Holmes Manufacturing is considering a new machine that costs $210, 000 and would reduce pretax manufacturing costs by $90, 000 annually. Holmes would use the 3-year MACRS method to depreciate the machine, and management thinks the machine would have a value of $24, 000 at the end of its 5-year operating life. The applicable depreciation rates are 33%, 45%, 15%, and 7%. Net operating working capital would increase by $26, 000 initially, but it would be recovered at the end of the project's 5-year life. Holmes's marginal tax rate is 40%, and a 13% WACC is appropriate for the project, a. Calculate the project's NPV. Round your answer to the nearest cent. Calculate the project's IRR. Round your answer to two decimal places. Calculate the project's MIRR. Round your answer to two decimal places. Calculate the project's payback. Round your answer to two decimal places. Assume management is unsure about the $90, 000 cost savings-this figure could deviate by as much as plus or minus 20%. What would the NPV be under each of these situations? Round your answers to the nearest cent. Negative amount should be indicated by a minus sign. Suppose the CFO wants you to do a scenario analysis with different values for the cost savings, the machine's salvage value, and the net operating working capital (NOWC) requirement. She asks you to use the following probabilities and values in the scenario analysis: Calculate the project's expected NPV, its standard deviation, and its coefficient of variation. Round your answers to two decimal places.

Explanation / Answer

a-1) NPV: INITIAL INVESTMENT: cost of the machine 210000 increase in working capital 26000 Total initial investment 236000 INCREMENTAL ANNUAL CASH FLOWS: 1 2 3 4 5 savings in manufacturing costs 90000 90000 90000 90000 90000 Less: depreciation on $210000 69300 94500 31500 14700 0 depreciation rates % 33 45 15 7 0 Net savings before tax 20700 -4500 58500 75300 90000 Less: tax at 40% 8280 -1800 23400 30120 36000 savings after tax 12420 -2700 35100 45180 54000 Add: depreciation 69300 94500 31500 14700 0 Incremental annual cash flows 81720 91800 66600 59880 54000 pvif @ 13% 0.8850 0.7831 0.6931 0.6133 0.5428 PV at 13% 72318.58 71892.87 46157.14 36725.53 29309.04 Sum of PVs 256403.15 TERMINAL CASH FLOWS: salvage value 24000 tax on capital gains -40% on 24000-0 -9600 release of working capital 26000 Net terminal cash flows 40400 PV at 13% (40400*0.5428) 21929.12 NPV: PV of annual cash inflows 256403.1524 PV of terminal cash flows 21929.12 PV of cash inflows 278332.2724 Less: initial investment 236000.00 NPV of the proposal 42332.27 a-2) IRR: Incremental annual cash flows 81720 91800 66600 59880 54000 add terminal cash flow 40400 81720 91800 66600 59880 94400 pvif @ 20% 0.8333 0.6944 0.5787 0.4823 0.4019 pv 68100 63750 38542 28877 37937 237206 pvif @ 21% 0.8264 0.6830 0.5645 0.4665 0.3855 pv 67537 62701 37594 27934 36395 232162 Exact IRR = 20 + (237206 - 236000)/(237206-232162)= 20.24 % a-3) MIRR: Incremental annual cash flows 81720 91800 66600 59880 94400 fvif @ 13% 1.6305 1.4429 1.2769 1.1300 1.0000 future value of the annual CFs 133242.30 132457.94 85041.54 67664.40 94400.00 cumulative FV 512806.19 MIRR = 6(512806.19/236000) - 1 = 0.1381 =13.81% a-4) Payback: Annual cash inflows 81720 91800 66600 59880 54000 cumulative cash flows 81720 173520 240120 300000 354000 Initial investment 236000 Pay back period = 2 + (236000-173520)/66600 = 2.94 years b) NPV of increase/decrease in savings: NPV for increase in savings: INITIAL INVESTMENT: cost of the machine 210000 increase in working capital 26000 Total initial investment 236000 INCREMENTAL ANNUAL CASH FLOWS: 1 2 3 4 5 savings in manufacturing costs 108000 108000 108000 108000 108000 Less: depreciation on $210000 69300 94500 31500 14700 0 depreciation rates % 33 45 15 7 0 Net savings before tax 38700 13500 76500 93300 108000 Less: tax at 40% 15480 5400 30600 37320 43200 savings after tax 23220 8100 45900 55980 64800 Add: depreciation 69300 94500 31500 14700 0 Incremental annual cash flows 92520 102600 77400 70680 64800 pvif @ 13% 0.8850 0.7831 0.6931 0.6133 0.5428 PV at 13% 81876.11 80350.85 53642.08 43349.37 35170.84 Sum of PVs 294389.25 TERMINAL CASH FLOWS: salvage value 24000 tax on capital gains -40% on 24000-0 -9600 release of working capital 26000 Net terminal cash flows 40400 PV at 13% (40400*0.5428) 21929.12 NPV: PV of annual cash inflows 294389.25 PV of terminal cash flows 21929.12 PV of cash inflows 316318.37 Less: initial investment 236000.00 NPV of the proposal 80318.37 NPV for decrease in savings: INITIAL INVESTMENT: cost of the machine 210000 increase in working capital 26000 Total initial investment 236000 INCREMENTAL ANNUAL CASH FLOWS: 1 2 3 4 savings in manufacturing costs 72000 72000 72000 72000 Less: depreciation on $210000 69300 94500 31500 14700 depreciation rates % 33 45 15 7 Net savings before tax 2700 -22500 40500 57300 Less: tax at 40% 1080 -9000 16200 22920 savings after tax 1620 -13500 24300 34380 Add: depreciation 69300 94500 31500 14700 Incremental annual cash flows 70920 81000 55800 49080 pvif @ 13% 0.8850 0.7831 0.6931 0.6133 PV at 13% 62761.06 63434.88 38672.20 30101.68 Sum of PVs 194969.83 TERMINAL CASH FLOWS: salvage value 24000 tax on capital gains -40% on 24000-0 -9600 release of working capital 26000 Net terminal cash flows 40400 PV at 13% (40400*0.5428) 21929.12 NPV: PV of annual cash inflows 194969.8255 PV of terminal cash flows 21929.12 PV of cash inflows 216898.9455 Less: initial investment 236000.00 NPV of the proposal -19101.05 c) SCENARIO ANALYSIS: Worst case NPV: INITIAL INVESTMENT: cost of the machine 210000 increase in working capital 31000 Total initial investment 241000 INCREMENTAL ANNUAL CASH FLOWS: 1 2 3 4 savings in manufacturing costs 72000 72000 72000 72000 Less: depreciation on $210000 69300 94500 31500 14700 depreciation rates % 33 45 15 7 Net savings before tax 2700 -22500 40500 57300 Less: tax at 40% 1080 -9000 16200 22920 savings after tax 1620 -13500 24300 34380 Add: depreciation 69300 94500 31500 14700 Incremental annual cash flows 70920 81000 55800 49080 pvif @ 13% 0.8850 0.7831 0.6931 0.6133 PV at 13% 62761.06 63434.88 38672.20 30101.68 Sum of PVs 194969.83 TERMINAL CASH FLOWS: salvage value 19000 tax on capital gains -40% on 19000-0 -7600 release of working capital 26000 Net terminal cash flows 37400 PV at 13% (40400*0.5428) 20300.72 NPV: PV of annual cash inflows 194969.8255 PV of terminal cash flows 20300.72 PV of cash inflows 215270.5455 Less: initial investment 241000.00 NPV of the proposal -25729.45 Best case NPV: INITIAL INVESTMENT: cost of the machine 210000 increase in working capital 21000 Total initial investment 231000 INCREMENTAL ANNUAL CASH FLOWS: 1 2 3 4 5 savings in manufacturing costs 108000 108000 108000 108000 108000 Less: depreciation on $210000 69300 94500 31500 14700 0 depreciation rates % 33 45 15 7 0 Net savings before tax 38700 13500 76500 93300 108000 Less: tax at 40% 15480 5400 30600 37320 43200 savings after tax 23220 8100 45900 55980 64800 Add: depreciation 69300 94500 31500 14700 0 Incremental annual cash flows 92520 102600 77400 70680 64800 pvif @ 13% 0.8850 0.7831 0.6931 0.6133 0.5428 PV at 13% 81876.11 80350.85 53642.08 43349.37 35170.84 Sum of PVs 294389.25 TERMINAL CASH FLOWS: salvage value 29000 tax on capital gains -40% on 29000-0 -11600 release of working capital 26000 Net terminal cash flows 43400 PV at 13% (40400*0.5428) 23557.52 NPV: PV of annual cash inflows 294389.25 PV of terminal cash flows 23557.52 PV of cash inflows 317946.77 Less: initial investment 231000.00 NPV of the proposal 86946.77 WORKING OF E(NPV), STD.DEVIATION AND COEFFICIENT OF VARIATION: d= Scenario Probability NPV NPV * p NPV - E(NPV) d^2 p*d^2 Worst case 0.35 -25729.45 -9005.31 -59855.19 3582644307.46 1253925507.61 Base case 0.30 42332.27 12699.68 8206.53 67347173.53 20204152.06 Best case 0.35 86946.77 30431.37 52821.03 2790061209.66 976521423.38 34125.74 2250651083.05 Expected NPV = $34,125.74 Std. Dev. Of NPV = 2250651083.05 = 47441.03 Coefficient of variation = Std Dev/Expected value = 47441.03/34125.74 = 1.39

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