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I need to help our client, Rondo, make a decision on whether or not
to go ahead with a project. I’d like you to do a net present value (NPV)
analysis on this special production project. The project will require
an initial investment in a piece of manufacturing equipment. The product
will be sold exclusively to the client over the next three years.
Please prepare an NPV analysis of the Rondo project. I have compiled
the following cost and sales estimates from engineering and marketing.
1. Project life is 3 years.
2. Initial investment is $7,550,000 for equipment invoice, transportation, and installation.
3. Worker training for operating new equipment is $18,000.
4. First-year sales are projected to be $4,500,000 escalated at 3.5% each year thereafter.
5. Operating overhead (excluding depreciation) is estimated at 27% of annual sales.
6. Administrative overhead is estimated at 35% of annual sales.
7. Depreciation is straight line, 5 years.
8. The tax rate is 40%.
9. The new equipment can be salvaged at the end of the project (end of YR 3) for $2,500,000.
10. Cost of capital is 10%.
You’ll need to create an Excel cash flow spreadsheet and calculate the NPV and IRR. Make your recommendation on the project.
A few observations:
1. Please do not forget how to treat the depreciation: first as an
item for the net income and then to add it back for the cash flows; and
it is straight line depreciation.
2. Worker training to be expensed in period 0. But keep in mind that you would want to view it on an after tax basis.
3. Please do not forget the terminal cash flow which depends on the salvage value and the remaining book value of the asset!
