Question

Square Manufacturing is considering investing in a robotics manufacturing line. Installation of the line will cost an estimated $9.8 million. This amount must be paid immediately even though construction will take three years to complete (years 0, 1, and 2). Year 3 will be spent testing the production line and, hence, it will not yield any positive cash flows. If the operation is very successful, the company can expect after-tax cash savings of $6.8 million per year in each of years 4 through 7. After reviewing the use of these systems with the management of other companies, Square’s controller has concluded that the operation will most probably result in annual savings of $5.0 million per year for each of years 4 through 7. However, it is entirely possible that the savings could be as low as $2.6 million per year for each of years 4 through 7. The company uses a 18 percent discount rate. Use Exhibit A.8.

Required:

Compute the NPV under the three scenarios. (Round PV factor to 3 decimal places. Enter your answers in thousands of dollars. Negative amounts should be indicated by a minus sign.)

NPV Best case, expected and worst case?

Answer 1

Scenario 1: Best

cash inflow $6.8 million i.e. $6800 thousand per year from year 4 to year 7.

Present value of the same using discount factor of 18% from year 4 to year 7 = 0.516 +0.437 +0.370 +0.314 = 1.637

Present value of cash saving = $6800 thousand * 1.637 =$11131.6 thousand.

NPV = Inflow - outflow

= $11131.6 thousand -$9800 thousand

NPV = $1331.6 thousand

Scenario 2: Expected

cash inflow per year = $5 million i.e. $5000 thousand

Present value of cash inflows = 1.637 * $5000 thousand = $8185 thousand

NPV = $8185 thousand - $9800 thousand

NPV = - $815 thousand

Scenario 3: Worst

cash inflow per year = $2.6 million i.e. $2600 thousand

Present value of cash inflows = 1.637 * $2600 thousand = $4256.2 thousand

NPV = $4256.2 thousand - $9800 thousand  

NPV = - $5543.8 thousand

Hence in expected and worst case the NPVs are negative and only in the best case there is positive NPV.