Question

1. A company is considering an investment of $4 million in a project that has a seven-year life. The company has estimated its discount rate at 12%. Details of the sales and costs associated with the project are as follows:

Sales volume	250,000 units per year
Sales price	$4 per unit
Costs
Direct materials (4 kg at $.40 per kg)	$1.60 per unit
Direct labor (0.1 hours at $8 per hour)	$0.80 per unit
Overhead	$330,000 per year

Note: The annual overhead includes $200,000 per year depreciation on the asset. It also includes apportioned fixed overhead of a further $50,000 per year.

1. Calculate the net present value of the project. Provide a commentary on the discounting process and on the net present value that you calculated.
2. Carry out a sensitivity analysis on the five variables of this project. Include the life of the project and the discount rate. Identify what you consider the most critical variable and advise management what they should do, if anything, before adopting the new project.
3. Advise the company on whether it should proceed with the project and provide reasons for your advice.

Answer 1

Answer A :-

NPV of the future cash flows :-

Total revenue = 250000*4 = 1000000

Total cost = (1.60*250000)+(0.80* 250000) + 330000

=930000

Total profit = 1000000- 930000= 70000

NPV of per year profit :-

End of year 1	62500
2	55804
3	49826
4	44487
5	39721
6	35463
7	31664
Total	319465

Answer B :-

5 main variables for sensitivity analysis are :-

1) Discounting rate

2) Life of project

3) Non fixed overheads

4) Depreciation accounting

5) Sales volume

Sensitivity analysis using change in overheads costs ( unfixed )

The total amount of overheads = 330000

The amount of unfixed overheads = 330000-200000-50000= 80000

Overhead	Per unit overheads cost	Per unit profit	% change in overheads cost	% change in profit
80000	0.32	0.28	-	-
70000	0.28	0.32	12.5%	14.29%
60000	0.24	0.36	25%	28.57%
50000	0.20	0.40	37.5%	42.86%
40000	0.16	0.44	50%	57.14%
30000	0.12	0.48	62.5%	71.42%
20000	0.8	0.52	75%	85.71%
10000	0.4	0.56	87.5%	100%

Answer C :-

Total depreciation for 7 years = 7*200000= 1400000

Salvage value = 4000000-1400000= 2600000

Total profit / loss of project = ( NPV of future cash flows + Salvage value ) - investment cost

= 2600000+ 319465- 4000000

=(1080535)

Thus the company should not opt for this project.