CASE STUDIES IN FINANCE -USE EXCEL
Ferrous Supplies, Inc., a manufacturer of finished steel
products from recycled metals and recycled ferrous and non-ferrous metal and
auto parts, is evaluating two mutually exclusive investment projects. In the
first project, the firm will supply 9,000 wheels annually to Ford Motor Company
at an average price of $700 per wheel over a period of 7 years. The second
project involves the supply of 12,500 auto exhaust systems annually to General
Motors Company at an average price of $400 per unit over a period of seven
The equipment required to produce the wheels will cost
$1,400,000 plus $100,000 in shipping and installation costs. This equipment has
an expected life of 10 years and will be depreciated using the MACRS 7-year
class life. After the 7-year contract with Ford Motor Company, this equipment
can be sold for 800,000, but the firm will need to pay $30,000 in removal
expenses. The production of the wheels will require an additional investment of
$500,000 in raw materials and the variable costs per wheel are estimated to be
70% of the selling price. The forecasted fixed costs associated with the wheels
include 10 workers to operate the equipment earning an average of $45,000 each
per year in salaries and benefits and $70,000 annually in maintenance costs and
miscellaneous fixed expenses. The equipment required to produce auto exhaust
systems will cost $1,200,000 plus $120,000 of shipping and installation
The expected life of
this equipment is 10 years and will be depreciated using the MACRS 7-year class
life. The equipment has an estimated salvage value of $155,000 after the 7-year
contract with General Motors Company, but the firm will need to pay $50,000 in
removal expenses. The production of the auto exhaust systems will require an
additional investment of $200,000 in raw materials and the variable costs per
unit are estimated to be 60% of the selling price. The forecasted fixed costs
associated with the systems include 12 workers to operate the equipment earning
an average of $38,000 each per year in salaries and benefits and $40,000
annually in maintenance expenses and miscellaneous fixed expenses.
The firm plans to finance the selected investment project
with a bank loan at a fixed rate of 5% for 7 years. The loan will be repaid in
periodic installments (annually). The workers’ salaries and benefits, and
maintenance expenses are expected to grow at an average rate of inflation of
3%. The firm’s WACC (Cost of Capital) is 12% and its marginal tax rate is 30%.
a) Calculate the
initial investment, annual after-tax cash flows, and the terminal cash flow of
each investment project.
b) Calculate the
payback period, NPV and IRR of each investment project. Should the firm accept
or reject one or both projects?
c) The firm’s management has decided to reconsider some
estimated variables that equipment costs, salvage value, and variable cost are
accurate within ∓25%. Create scenario analysis showing
the riskiness of this project to the possible changes in equipment cost,
salvage value and variable cost. Include a graph in your analysis. Under which
scenario the project should be selected?
d) Perform the same sensitivity analysis (use increments of
2% from -10% to 10%) for the following uncertain variables: number of units,
variable cost as a percentage of sales, investment in net working capital,
salvage value, and inflation rate. Create a sensitivity diagram that includes
all of these variables.
e) Perform the Break-Even Analysis (accounting and
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