Stark Industries is considering adding a vibranium shield to the Iron Man Suits the company manufactures for the U.S. Armed Forces. The equipment to build the shields has a purchase price of $1,275,000, and the company will spend $75,000 to ship the equipment to its plant and install it on the production floor. Stark Industries engineers expect the machine to have a $25,000 salvage value at the end of its 10-year life and a practical capacity of 1,200 shields per year.The new equipment requires an average of $35,000 investment in working capital to keep the equipment running efficiently; the $35,000 investment in working capital is fully recoverable at the end of the investment.

Stark Industries' current weighted average cost of capital is 17%. The estimate may vary by +/- 1.00% depending on market conditions.

Stark Industries' negotiations with its union regarding the staffing of the new shield-manufacturing machine resulted in the firm agreeing to hire new workers and pay them $200,000 annually. The union agreement also stipulated that the employees have the option to request a salary revision after the fifth year of the agreement of up to 6% of the agreed salary. Stark's human resources department estimates that the renegotiation with the union will result in a 2%, 3%, 4% or 5% labor cost increase with a probability of 15%, 40%, 35% and 10%, respectively. The company also agreed to invest $50,000 to train the new employees on the equipment when hired. Training the new employees will be on the job, which will likely reduce the output for the first year of the project by 100 shields; in the worst-case scenario, the decrease in output would be 20%.

Each shield consumes $575 worth of vibranium (imported from Wakanda).Recent contract negotiations with Wakanda and King T'Challa have locked-in this cost for the next five years and specify an increase to $600 per shield thereafter.

The current contract negotiated with the U.S. Armed Forces guarantees a price of $1,100 per shield for the first 5 years in the contract. Tony Stark, Stark Industries' CEO, believes it is unlikely the government will require a reduction of more than 20% of the price per shield in the next contract negotiation. Exhibit 1 indicates Tony's assessment of the revised contract prices with their estimated probabilities of realization.

Common practice in the tax department of Stark Industries is to depreciate the full value of any acquired assets regardless of their salvage values. Pepper Potts (Stark Industries CFO) determined the equipment is 7-years class property (see depreciation percentages for this type of property in Exhibit 2). Stark Industries is subject to a 26% tax rate (21% corporate tax rate plus 5% blended rate of state taxes).

Exhibit 1: Government Contract Renegotiation Estimates:

RENEGOTIATIED PRICE

PROBABILITY

1,100

5%

1,020

15%

980

25%

930

30%

880

25%

Exhibit 2: Depreciation Schedule (in percentages) for 7-year property.

1 14.29

2 24.49

3 17.49

4 12.49

5 8.93

6 8.92

7 8.93

8 4.46

Required (Please, provide supporting schedules for all your answers):

I.[50 points; content 40 points, modeling 10 points] Determine the NPV of the project. Clearly state the assumptions for your calculations. (Hint: since you will be evaluating more than one scenario, it will be in your best interest to use formulas and cell references in your Excel worksheets. This is a good opportunity to practice your worksheet modeling skills.)

II.[30 points] Using the information on the project and the assumptions you made in part I indicate the following:

a.[5 points] What is the Internal Rate of Return of the project?

b.[5 points] What is the after-tax payback period of the project?

c.[5 points] What is the after-tax discounted payback period of the project?

d.[10 points] How sensitive is the viability of the project to the choice hurdle rate assumptions you made part I? (Indicate the NPV for each of the alternative hurdle rates you use).

e.[5 points] What will be the lowest price that Stark Industries may be able to accept upon contract renegotiation in year 5 that would continue to make (or would make) the project viable (i.e., the NPV = 0)?

III.[10 points] Assume that Ms. Potts has been evaluating the tax proposals going around in the Legislature. She has concluded that the tax rates could go up as high as 30% or as low as 23% depending on political negotiations. She assumes that any such changes will be effective starting on the third year of the project's life.

a.[5 points] What would be the NPV of the project if the tax rate goes up to 30% starting on the third year of project implementation? What would be the Internal Rate of Return based on this scenario?

b.[5 points] What would be the NPV of the project if the tax rate goes down to 23% starting on the third year of project implementation? What would be the Internal Rate of Return based on this scenario?

IV.[25 points] Sensitivity analysis.

a.[20 points] In addition to the scenarios calculated above, calculate the NPV under the most optimistic set of assumptions and the most pessimistic set of assumptions and summarize the NPV and IRR calculation for each scenario. (For this requirement, you must combine the best and worst possible scenarios given all the information included in the case.) Please be explicit about your assumptions for each scenario.

b.[5 points] Briefly, comment on the importance of conducting sensitivity analysis when evaluating long-term capital investments.

V.[10 points] Based on the data you have obtained throughout the exercise; would you recommend Stark Industries to accept the project?