Question

123 Inc. is considering purchasing a new machine. The machine will cost $3,250,000. The machine will be used for a project that lasts 3 years. The expected salvage of the machine at the end of the project is $800,000. The machine will be used to produce widgets. The marketing department has forecasted that the company will be able to sell 280,000 widgets per year. The marketing department believes that the company will be able to charge $22 per widget. The production department, has indicated that the variable cost per widget will be $9. The company has forecasted that the incremental fixed costs associated with the project are $120,000 per year. The company believes that the project will require an initial investment in operating net working capital of $160,000. Thereafter, the investment in operating net working capital will be 8% of sales. Assume the asset class remains open.

The CCA( Capital Cost Allowance) rate is 30%, the tax rate is 24%, and the required rate of return is 8%.

1. Using net present value (NPV) calculation, determine if the company should purchase the new machine. Show all work.
2. Your boss has a number of concerns regarding the project. Therefore, she has asked you to determine the number of units that the company must sell each year for the NPV to be greater than zero.
3. Your boss has also asked you to determine which input (units sold, price per unit, variable cost per unit, or fixed cost) has the greatest forecasting risk. Therefore, your boss has asked you to do a sensitivity analysis. Your boss wants you to vary the input forecast by 10% and determine the impact on the NPV of the project. Based on this analysis you are to determine which input has the greatest forecasting risk.
4. Finally, your boss has asked you to perform a scenario analysis. Therefore, your boss has asked to include two new scenarios. A pessimistic scenario and an optimistic scenario. Your boss wishes to know the NPV of the project under these two additional scenarios. The value of the inputs for each scenario are shown in the table below.

	Pessimistic	Optimistic
Units sold	180,000	400,000
Price per unit	$16	$32
Variable cost per unit	$12	$7
Fixed Cost	$150,000	$80,000

Answer 1

a) Cost of the Machine = $ 32,50,000

Initial Investment in Net Working Capital = $ 1,60,000

Year 1 Year 2 Year 3

Sales ($22*2,80,000) 61,60,000 61,60,000 61,60,000

Variable Cost ($9*2,80,000) (25,20,000) (25,20,000) (25,20,000)

Incremental Fixed cost (1,20,000) (2,40,000) (3,60,000)

Operating Net Working Capital (4,92,800) (4,92,800) (4,92,800)

___________ ____________ ___________

30,27,200 29,07,200 27,87,200

Less: Tax (4,92,528) (4,63,728) (4,34,928)

____________ __________ __________

Profit After Tax    25,34,672 24,43,472 23,52,272

Salvage Value - - 8,00,000

___________ ___________ ___________

25,34,672 24,43,472 31,52,272

ROR @8% 23,46,919 20,94,883 24,86,476

NPV= $ (23,46,919 + 20,94,883 + 24,86,476 - 32,50,000 - 1,60,000) = $ 35,18,278

Therefore, as the NPV is positive, the Company should purchase the new machine.