Company X is looking to expand their operations to add a second product line capable of producing 1.25 Million units per year. The total estimated investment cost for the new line is $25 Million, with a salvage value equal to 20% of the purchase price at the end of the 6-year project life. The annual expected sales volume is shown below, in thousands of units: Year 1 2 3 4 5 6 Volume 525,000 600,000 725,000 800,000 925,000 1,000,000 The average selling price is fixed for the project life at $125 per unit. Variable costs (per unit) include $35 for materials, $20 for manufacturing, and $18 for labor. There are additional fixed operating and maintenance costs totaling $14.25 Million per year. The company’s working capital calculations are based on a 2.5-month supply of raw materials and 1.5 months of combined inventory (WIP and finished goods) that it maintains to balance overall industry demand. FX has a federal tax rate of 23% and a state tax rate of 8.75%. FX uses a MARR of 18% for all economic analyses. Inflation is expected to increase the variable and fixed costs by 6.4% after the first year. In years 3- 6, inflation is expected to decline by 1.2% each year. In other words, year 2 inflation is 6.4%, year 3 is 5.2%, etc. The project falls under a 7-year MACRS class life. Question 1) This project can move forward without outside financing. What is its Present Worth? What is the cost and margin per unit by year? If the company has an inflation-independent alternative with NPV(18%) of $8m, how much does the base inflation rate have to increase to recommend against this project? Question 2) Alternatively, the company can finance $18 Million of the initial investment (5 annual payments at 12.5%). Based on net present value analysis, which approach (pay cash as in #1, or finance as in #2) do you advise them to take? What interest rate would make these alternatives equivalent?
Company X is looking to expand their operations to add a second product line capable of producing 1.25 Million units per year. The total estimated investment cost for the new line is $25 Million, with a salvage value equal to 20% of the purchase price at the end of the 6-year project life.
The annual expected sales volume is shown below, in thousands of units:
Year 1 2 3 4 5 6
Volume 525,000 600,000 725,000 800,000 925,000 1,000,000
The average selling price is fixed for the project life at $125 per unit. Variable costs (per unit) include $35 for materials, $20 for manufacturing, and $18 for labor. There are additional fixed operating and maintenance costs totaling $14.25 Million per year. The company’s working capital calculations are based on a 2.5-month supply of raw materials and 1.5 months of combined inventory (WIP and finished goods) that it maintains to balance overall industry demand. FX has a federal tax rate of 23% and a state tax rate of 8.75%. FX uses a MARR of 18% for all economic analyses. Inflation is expected to increase the variable and fixed costs by 6.4% after the first year. In years 3- 6, inflation is expected to decline by 1.2% each year. In other words, year 2 inflation is 6.4%, year 3 is 5.2%, etc. The project falls under a 7-year MACRS class life.
Question 1) This project can move forward without outside financing. What is its Present Worth? What is the cost
and margin per unit by year? If the company has an inflation-independent alternative with NPV(18%)
of $8m, how much does the base inflation rate have to increase to recommend against this project?
Question 2) Alternatively, the company can finance $18 Million of the initial investment (5 annual payments at
12.5%). Based on
do you advise them to take? What interest rate would make these alternatives equivalent?
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