Question
North State Manufacturing is considering a contract for a project to supply Detroit Automotive Solutions with 30,000 tons of machine screws annually for automobile production.
North State Manufacturing is considering a contract for a project to supply Detroit Automotive Solutions with 30,000
tons of machine screws annually for automobile production. North State Manufacturing 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 $925,000 and that variable costs should be $280 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 $400 per ton. The engineering department estimates that North State Manufacturing will
need an initial net working capital investment of $500,000, 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. Also consider, that the North State Manufacturing is offered a similar
contract with Automoville, Inc. that has an expected net present value of $850,000, a payback period of 4.2 years, and
IRR of 25%, but it comes with a non-compete clause that will not allow you to pursue the contract with Detroit
Automotive Solutions. North State Manufacturing requires a return of 13.75 percent and face a marginal tax rate of
30 percent on this project. You are a Financial Analyst in the Corporate Finance Division and have been tasked by
North State Manufacturing's VP-Capital Projects, Cynthia Barlow, to evaluate this project. The VP would like to
know the following in an executive summary:
What is the base case scenario NPV of the Detroit Automotive Solutions contract? What is the IRR for the base-case
scenario? What is the payback period for the base-case scenario of the Detroit Contract?
What is the sensitivity of the project NPV to changes in the quantity supplied NPV/Q?
What is the sensitivity of the project NPV to changes in the variable costs NPV/VC?
What is the sensitivity of the project NPV to changes in the fixed costs NPV/FC?
Which of these items have the greatest impact on the project's NPV?
Cynthia Barlow is a little unsure about Detroit 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.)
Due to potential changes in the economic environment, Cynthia Barlow is not as confident in the original
projections. So, she request that you evaluate not only the base-case scenario, but also, the worst-case, and best-case
scenarios for the firm. What is the worst-case scenario NPV of the Detroit Automotive Solutions contract? What is
the best-case scenario NPV of the Detroit Automotive Solutions contract?
Further, you contact your Economic Forecasting Division and they provide you with the estimated probabilities of a
30, 50%, and 20% for the best-case, base-case, and worst-case scenarios, respectively. What is the expected NPV
payoff of the Detroit Automotive Solutions contract? Do you recommend that the firm should pursue the contract
with Detroit Automotive Solutions or the contract with Automoville Inc.? Why?
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