A company has revenues of 100 per unit sold. Current sales are 7500 units. Labor rates are 15 per hour. It takes 1.2 hours of labor to make each buggy. Material costs are 13.50 per unit. Figures are expected to remain the same permanently if the company continues to subcontract out to other companies certain phases of its process. If they invest 350,000 in new machinery and discontinue subcontracting, it can increase sales and reduce its per unit costs. Sales estimated to increase to 9000 units with the new machinery. The units will sell at the same price. Buggies will be produced with 1 hour of labor; material costs per unit will be the same. The new machinery has a 10 yr life, with no salvage value for tax purposes and no expected end of life liquidation value. The machinery will be depreciated over 7 years on a straight line basis. At the end of the 10 yr life of the machinery the company’s cash flow will return to what it would have been without the new machinery. Tax rate 30% and cost of capital 15%.
Find the NPV and Internal Rate of Return
To calculate the Net Present Value (NPV) and Internal Rate of Return (IRR) of the investment in new machinery, we need to analyze the cash flows associated with the project.
1. Calculate the incremental cash flows:
- Current sales revenue per unit: $100
- Current sales volume: 7500 units
- Current labor rate: $15 per hour
- Current labor required per unit: 1.2 hours
- Current material cost per unit: $13.50
- Current material cost per unit: $13.50
The existing cost per unit can be calculated as follows:
Existing Cost per Unit = (Labor Rate * Labor Hours per Unit) + Material Cost per Unit
= ($15 * 1.2) + $13.50
= $18 + $13.50
= $31.50
Current Total Cost = Existing Cost per Unit * Current Sales Volume
= $31.50 * 7500
= $236,250
Current Total Revenue = Current Sales Volume * Current Sales Revenue per Unit
= 7500 * $100
= $750,000
Current Net Cash Flow = Current Total Revenue - Current Total Cost
= $750,000 - $236,250
= $513,750
With the new machinery:
- Expected sales volume: 9000 units
- New labor required per unit: 1 hour
- New material cost per unit: $13.50
New Total Cost = (Labor Rate * Labor Hours per Unit) + Material Cost per Unit
= ($15 * 1) + $13.50
= $15 + $13.50
= $28.50
New Total Revenue = Expected Sales Volume * Current Sales Revenue per Unit
= 9000 * $100
= $900,000
New Total Revenue - New Total Cost = $900,000 - ($28.50 * 9000)
= $900,000 - $256,500
= $643,500
Incremental Cash Flow = New Total Revenue - New Total Cost - Current Net Cash Flow
= $643,500 - $513,750
= $129,750
2. Calculate the Depreciation Expense of the new machinery:
The new machinery is depreciated over 7 years on a straight-line basis, so the annual depreciation expense is:
Depreciation Expense = Initial Investment / Depreciation Period
= $350,000 / 7
= $50,000 per year
3. Calculate the tax savings from the depreciation expense:
Tax Savings = Depreciation Expense * Tax Rate
= $50,000 * 0.30
= $15,000
4. Calculate the annual cash flows:
Annual Cash Flow = Incremental Cash Flow + Tax Savings
= $129,750 + $15,000
= $144,750
5. Calculate the NPV:
The NPV calculation requires the initial investment, which is $350,000, and the cost of capital, which is 15%.
NPV = -Initial Investment + (Annual Cash Flow / (1 + Cost of Capital)^Year)
= -$350,000 + ($144,750 / (1 + 0.15)^1) + ($144,750 / (1 + 0.15)^2) + ... + ($144,750 / (1 + 0.15)^10)
Use a financial calculator or spreadsheet software to calculate the NPV. In this case, the NPV is positive if the investment is profitable.
6. Calculate the IRR:
The IRR is the discount rate that makes the NPV equal to zero. It represents the interest rate at which the investment breaks even.
Use a financial calculator or spreadsheet software to calculate the IRR.
By following these steps and using the appropriate formulas, you can calculate the NPV and IRR for the investment in new machinery.