A case about Internal Rate of Return (IRR) and Net Present Value (NPV):
Company B after spending $250,000 on a feasibility study, has determined that its customers will be willing to pay more money for a model if it invests in a manufacturing technology upgrade. Thanks to the feasibility study, the managers see the opportunity to make a short-term investment in a new technology that will affect the next eight years of production in order to improve their overall offering to their customers.
Because the new model’s production facilities are already covered in original cost estimates, no additional costs for production facilities are required. However, the required new machinery will cost $1,500,000 and will be subject to capital cost allowance depreciation at 20%. When the new model program expires after year eight, there will be $283,116 in salvage on the equipment. Sales across the eight years of the program are projected to be 20 units, 25 units, 30 units, 45 units, 60 units, 40 units, 40 units, and 40 units.
The company expects the price to their customers will start at an additional $100,000 with two per cent increases per year, as they wish to keep their prices competitive. Material costs of production are expected to be $64,000 per unit, growing at five per cent a year. Fixed costs per annum will amount to $750,000. The corporate tax rate the company is subject to is 26.8 per cent, as of end of fiscal 2015.
Finally, the company requires a maintained investment in working capital of $400,000 at the beginning of the project. This will stay at 15 per cent of sales at the end of each year, and reduces to 0 by the project's end; therefore, the investment in working capital is fully recovered by the project's end. As the company will be purchasing raw materials prior to production and sales delivery, they must create an investment in inventory as well as maintaining some cash as a buffer against unforeseen expenses. If the firm has negative taxable income from the project in a given year, please assume that the firm has positive income from other projects, so that the loss can be written off (as a tax benefit) against this other project income in the same year.
Questions:
What is the Internal Rate of Return on the project?
What is the Net Present Value of the project if the required rate of return (Weighted Average Cost of Capital) is equal to 3.80 per cent?
By how much would the Net Present Value of the project change if unit sales were 25 per cent less than expected (round down toward zero the number of units)?