Question
The Smith company, a manufacturer of industrial parts, is evaluating two mutually exclusive projects A&B. The projects are somewhat riskier than the usual projects the
The Smith company, a manufacturer of industrial parts, is evaluating two mutually exclusive projects A&B. The projects are somewhat riskier than the usual projects the firm undertakes; management uses the subjective approach and decided to apply an adjustment factor of +2% to the cost of capital for both projects.
The companys a marginal tax rate is 21%, and cost of capital is 11%, evaluate the following proposals.
Project A: is a six-year project that requires an initial fixed asset investment of $3 million. The fixed asset falls into the seven-year MACRS class. Based on $20 per unit sale price, the project is estimated to generate $2,050,000 in sales during its first year, with production costs of $950,000. Sales and costs are expected to grow at 3% annually. The project requires a single initial investment in net working capital of $285,000 which is expected to be recovered in six years when the project is terminated. The fixed asset will have a market value of $225,000 at the end of its six years life.
Project B: is also a six-year project that requires an initial fixed asset investment of $1.9 million that falls into the seven-year MACRS class. The fixed asset will also require an additional $100,000 in shipping and installation. The marketing firm predicts that first year sales related to the project will be 62,500 units, at a price of $16 per unit, and grow at an annual rate of 4%. Operating costs related to the project are predicted to be 22% of sales. The project will also require an initial net working capital investment of $150,000 which is expected to be recovered at the end of six years. The asset is expected to have a market value of $22,000 at the end of the six years when the project is terminated.
The MACRS tax rates are given below:
Year | 3 | 5 | 7 |
1 | 33.33% | 20.00% | 14.29% |
2 | 44.44% | 32.00% | 24.49% |
3 | 14.81% | 19.20% | 17.49% |
4 | 7.41% | 11.52% | 12.49% |
5 |
| 11.52% | 8.92% |
6 |
| 5.76% | 8.92% |
7 |
|
| 8.92% |
8 |
|
| 4.46% |
1) Calculate both projects cash flows for years 0-6
2) Calculate NPV, IRR and PI for both projects
3) Which project should be accepted if any and why?
4) What is the exact NPV profiles crossover rate (incremental IRR)? And what is the relevance of this rate?
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