Question

The Rustic Welt Company is proposing to replace its old welt-making machinery with more modern equipment. The new equipment costs $12 million, is expected to last 9 years and has no salvage value. The existing equipment has a zero salvage value. The new machinery is expected to cut manufacturing costs from their current level of $7 per unit to $3. However, as the following table shows, there is uncertainty about future sales and unit costs. The opportunity cost of capital is 10%. Ignore taxes. Conduct a sensitivity analysis of the replacement decision. (12)

	Pessimistic	Expected
Sales in millions of welts	0.5	0.6
Manufacturing cost per welt	$5	$3

Answer 1

Computation of NPV:

Pessimistic     Expected

Per Unit saving in manufacturing costs $2 $4

Sale of welts per year (In millions) 0.5 0.6

Saving per year   (In millions)   $1 $2.40

PVIFA(10%, 9 years) 5.760 5.760

PV of Savings (In millions)   5.760 13.824

Less: PV of Initial Investment (In millions) (12)    (12)

NPV   (In millions) (6.24) 1.824

Sensiitvity to Initial Project Cost:

Initial Project Cost (Base) (In millions) (12)    (12)

Initial Project cost required to make NPV=0 5.760 13.824

Margin (Change) (6.24) 1.824

Sensitivity (Change/Base) (%)   (52%) 15.20%