Precision Tools is considering a 5-year project to improve its production effici

Question

Precision Tools is considering a 5-year project to improve its production efficiency. A new machine press will cost $760,000 and will be depreciated on a straight-line basis to zero over the life of the project. The project will require an investment in inventory of $18,000, will decrease accounts payable by $3,000 and decrease accounts receivable by $2,000. All net working capital will be recovered at the end of the project.

Last year, Precision tools sold 5,000drills for $200 each ad 4,000 saws for $240 each. They estimate that this new project will reduce the variable cost of drills from $100 to $85, and reduce the variable cost of saw from $170 to $160. The project will also increase fixed production costs by $2,000 annually. Precision Tools plans to lower the price of drills to $190 and estimates that this will increase sales to 6,500 units. They will not lower the price of saws, and expect sales to remain the same.

a. Identify the project cash flows for each year.

b. Calculate the IRR for this project.

c. What is the NPV for this project? Use the WACC from question 1.

d. Should Technology Inc. accept or reject this project? Explain.

e. Precision Tools. faces flotation costs of 8% for debt, 5% for common stock, and 4% for preferred stock.

i. Calculate the true cost of capital spending if Precision Tools. uses external funding to purchase the new fixed assets.

ii. Recalculate NPV. Will flotation costs change your decision to accept or reject the project?

f. Identify one additional tool you could us to evaluate this project. Why would you us that tool. Identify any disadvantages associated with your chosen tool.

g. Suppose you discovered that this project is riskier than the projects usually pursued by Precision Tools. Explain how that information would affect your analysis and your decision to accept or reject.

Explanation / Answer

Cost of new machine 760000 useful life 5 year Working capital: investment in inventory 18000 decrease in payable 3000 decrease in AR -2000 WC requirement 19000 Drills Saws total Sale units 6500 4000 SP 200 240 saving in VC 15 10 total VC savings 97500 40000 137500 Increase in FC 2000 Net savings 135500 year 0 1 to 5 5 Cashouflow -779000 Cash inflow 135500 Cash inflow-year 5 19000 DF 1 3.99271 0.68058 Dis cashflow -779000 541012.205 12931.02 NPV -225056.775 IRR negative Project should not be accepted as it has a negative NPV

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