Florida Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year tax life, would be depreciated on a straight-line basis over the project's 3-year life, and would have a zero salvage value after Year 3. No new working capital would be required. Revenues and other operating costs will be constant over the project's life, and this is just one of the firm's many projects, so any losses on it can be used to offset profits in other units. If the number of cars washed declined by 40% from the expected level, by how much would the project's NPV change? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.)
Net investment cost (depreciable basis) $60,000
Number of cars washed 2,820
Average price per car $25.00
Fixed op. cost (excl. depr.) $10,000
Variable op. cost/unit (i.e., VC per car washed) $5.375
Annual depreciation $20,000
Tax rate 35.0%
This solution illustrates how to perform a sensitivity analysis if a sales goal is not met.
NPV, IRR, and Sensitivity Analysis
Crumbly Cookie Company is considering expanding by buying a new (additional) machine that costs $42,000, has zero terminal disposal value and a 10-year useful life. It expects the annual increase in cash revenues from the expansion to be $23,000 per year. It expects additional annual cash costs to be $16,000 per year. Its cost of capital is 6%. Ignore taxes.
1. Calculate the net present value and internal rate of return for this investment.
2. Assume the finance manager of Crumbly Cookie Company is not sure about the cash revenues and costs. The revenues could be anywhere from 10% higher to 10% lower than predicted. Assume cash costs are still $16,000 per year. What are NPV and IRR at the high and low points for revenue?
3. The finance manager thinks that costs will vary with revenues, and if the revenues are 10% higher, the costs will be 7% higher. If the revenues are 10% lower, the costs will be 10% lower. Recalculate the NPV and IRR at the high and low revenue points with this new cost information.
4. The finance manager has decided that the company should earn 2% more than the cost of capital on any project. Recalculate the original NPV in #1 using the new discount rate and evaluate the investment opportunity.
5. Discuss how the changes in assumptions have affected the decision to expand.
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