Capital Budgeting

NorCal Enginnovation is considering a contract for a project to supply Bay Area Automotive Solutions with 35,000 tons of machine screws annually for automobile production. NorCal Enginnovation will need an initial $4,500,000 investment in threading equipment to get the project started; the project will last for six years. The accounting department estimates that annual fixed costs will be $1,025,000 and that variable costs should be $290 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the six-year project life. It also estimates a salvage value of $500,000 after dismantling costs. The initial investment and salvage value are accurate within +/- 8% of the initial projections. The marketing department estimates that the automakers will approve the contract at a selling price of $388 per ton. The engineering department estimates that NorCal Enginnovation will need an initial net working capital investment of $600,000, but management expects to recover their net working capital in the terminal year of the project. Consider, the units produced, sales price, variable costs, and fixed costs to be accurate within +/- 10% of the projections. Unfortunately, a cheaper line of screws that are sold by NorCal Enginnovation to Bay Area Automotive Solutions is expected to decrease by 2,500 tons annually for the length of the project. This cheaper line of screws are sold at a price of $290 per ton and has a variable cost of $210 per ton. Also consider, that the NorCal Enginnovation is offered a similar contract with CAMobility, Inc. that has an expected net present value of $1,900,000, a payback period of 4.2 years, and IRR of 18.25%, but it comes with a non-compete clause that will not allow you to pursue the contract with Bay Area Automotive Solutions. NorCal Enginnovation requires a return of 14.25 percent and faces a marginal tax rate of 21 percent on this project. Your group works in the Corporate Finance Division and have been tasked by NorCal Enginnovations VP-Capital Projects, Khalila Price, to evaluate this project. The VP would like to know the following in an executive summary:

1. Khalila Price is a little unsure about Bay Area Automotive Solutions actual machine screw requirements. So, she also wants to know the minimum level of output that you recommend, the company should not drop below under the base case scenario. (Calculate both accounting and financial break-even but recommend which of these estimates is most useful.)