Question

Howell Petroleum is considering a new project that complements its existing business. The machine required for the project costs $3.82 million. The marketing department predicts that sales related to the project will be $2.52 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. Howell also needs to add net working capital of $170,000 immediately. The additional net working capital will be recovered in full at the end of the project’s life. The corporate tax rate is 40 percent. The required rate of return for the project is 14 percent.

[Use Excel to answer the questions.]

1. What is the NPV and IRR of the project? Is the project acceptable?  

2. Do the following scenario analyses:

1. What if the sales level is 50% higher than the current estimate? Compute the NPV and IRR of the project.
2. What if the sales level is 75% higher than the current estimate? Compute the NPV and IRR of the project.
3. What if the sales level is 50% lower than the current estimate? Compute the NPV and IRR of the project.
4. What if the sales level is 75% lower than the current estimate? Compute the NPV and IRR of the project.

3. What is the breakeven price of the machine? (What price of the equipment will make the NPV equal zero?)

Answer 1

Calculation of NPV

At period 0, Outflow= $3.82mln + S170,000 = $3.99 mln

Inflow:- Income from sales for 4 years = [($2.52mln*.75)-$3.82 mln/4]*60%+$3.82mln/4=$1.516 mln per year

At 14% expected return for 4 years, we get:- $ 4.423 Mln (approx.)

Extra inflow $170,000 at the end of 4 years at 14% return = $100,654

NPV = 4.423 mln + 100,654 - 3.99 mln = $ 533,654 (approx.)

Calculation of internal rate of return:-

Cash outflow at year 0 = $3.99 mln

Cash inflow at year 1-3 = 1.516 mln per year

Cash inflow at year 4 = $1.516 mln + 170,000= $ 1.686 mln

Using trial and error and interpolation of 20% & 21%, we get IRR=20.215%

The project is acceptable.

P.S- Considering the amount of calculation, I'm calculating only one full question.