Problem
A drug firm manufactures and sells generic over-the-counter drugs in plants located throughout the country. One of its plants is trying to decide whether to automate a portion of its packaging process by purchasing an automated waste disposal and recycling machine.
The proposed machine costs $400,000 and it will have a five year anticipated life and will be depreciated by using 3-year MACRS depreciation method toward a zero salvage value. (MACRS depreciation rates are: Year 1: 33%, Year 2: 45%, Year 3: 15% and Year 4: 7%) However, the plant will be able to sell the machine in the after-market for 25% of its original costs at the end of year 5. The firm estimates that the installation of the waste-handling system will bring annual costs savings of $25,000 from reduced labor costs, $10,000 per year from reduced waste disposal costs, and $125,000 per year from the sales of reclaimed plastic waste net of selling expenses. The firm requires a 16% of return from its investment and faces a 35% tax rate.
Q1. Calculate the NPV and IRR for the project. Should the firm invest in this machine?
Q2. The manager of the plant raised some concerns about the revenues from the sale of reclaimed plastic waste. He projects that the price of the reclaimed plastic in year 1 could be 10% to 50% less than what was projected. However, the savings from reduced labor costs and reduced waste disposal costs would remain same. He presented the following probability distribution on the projected reclaimed plastic sales:
Remain same as projected 40%
Decrease by 10% 30%
Decrease by 30% 20%
Decrease by 50% 10%
Estimate the NPV and IRR for each of these scenarios. Estimate the expected NPV. Should the company invest in the machine under this revised analysis?
Q3. At what sales volume of reclaimed plastic, the firm would have a break-even NPV=0?