Five-Year Manifold Project and a Below-Cost Special Order
Northgate Components is evaluating a five-year project to produce a new line of hydraulic manifolds. Equipment costs $4,200,000, qualifies as five-year MACRS property (rates of 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%), and has no expected salvage value. The project requires $400,000 of working capital at the start, all of which is recovered at the end of year six. Incremental revenue is expected to be $3,600,000 per year and incremental cash operating costs are 62% of revenue. Northgate's marginal tax rate is 25% and its weighted average cost of capital for this risk class is 11%. Separately, a long-standing customer has asked Northgate to supply 5,000 units of an existing manifold at $70 per unit, well below the normal $86 price. The plant has idle capacity, but the order requires $250,000 of special tooling with no resale value, and it would displace 1,000 units of regular business that cannot be rescheduled. Variable cost is $48 per unit; fixed overhead of $1,900,000 per year is allocated at $38 per unit at normal volume of 50,000 units.
1. Compute the project's after-tax operating cash flows and net present value.
Read the worked answer
Annual EBITDA: $3,600,000 x 38% = $1,368,000.
After-tax cash flow = (EBITDA - depreciation) x (1 - 25%) + depreciation:
| Year | Depreciation | Taxable income | Tax | OCF |
|---|---|---|---|---|
| 1 | 840,000 | 528,000 | 132,000 | 1,236,000 |
| 2 | 1,344,000 | 24,000 | 6,000 | 1,362,000 |
| 3 | 806,400 | 561,600 | 140,400 | 1,227,600 |
| 4 | 483,840 | 884,160 | 221,040 | 1,146,960 |
| 5 | 483,840 | 884,160 | 221,040 | 1,146,960 |
| 6 | 241,920 | 1,126,080 | 281,520 | 1,086,480 |
Discounting at 11% (factors: 0.9009, 0.8116, 0.7312, 0.6587, 0.5935, 0.5346):
- PV of OCFs: 1,113,500 + 1,105,400 + 897,600 + 755,500 + 680,700 + 580,900 = $5,133,600
- PV of working capital recovery: $400,000 x 0.5346 = $213,900
- Total PV of inflows: $5,347,500
- Initial outlay: $4,200,000 + $400,000 = $4,600,000
- NPV = $747,500 (approximately $747,000)
Judgment points. (1) The sixth year exists only because of the half-year convention's 5.76% residual depreciation; omitting it overstates taxes in year 5. (2) The working capital outlay is not depreciable and is recovered at the end of year six, discounted at the year-six factor. (3) Depreciation is added back because it is noncash; the tax shield is already captured through the tax line. A positive NPV of about 16% of the outlay is a modest margin for a project with this level of forecast risk.
2. Evaluate the special order quantitatively. Should Northgate accept it?
Read the worked answer
Relevant (incremental) analysis - only costs and revenues that change with the decision:
| Item | Amount |
|---|---|
| Incremental revenue (5,000 x $70) | +$350,000 |
| Variable cost (5,000 x $48) | -$240,000 |
| Special tooling (no resale value) | -$250,000 |
| Lost contribution on displaced regular units (1,000 x ($86 - $48)) | -$38,000 |
| Net effect on operating income | -$178,000 |
Conclusion: reject the order on quantitative grounds.
Traps the exam tests. The allocated fixed overhead of $38 per unit is irrelevant - it does not change with the order and the plant has idle capacity, so including it is a classic error. But an order priced above variable cost is not automatically acceptable: the $250,000 nonrecurring tooling must be recovered, and the displacement of 1,000 full-price units costs $38,000 of contribution. Ignoring either item produces the wrong answer - a naive analysis shows $110,000 of contribution and misses that the tooling alone consumes it. Note that the displacement effect is measured at contribution margin, not at revenue, and that the $70 price still exceeds variable cost, so the order becomes viable if the tooling can be spread over additional volume or if the displaced units can be rescheduled.
Sensitivity. The order breaks even at roughly 5,000 units only if tooling falls to about $72,000 or the price rises to about $105. Alternatively, quoting $105.60 per unit (a 50.9% increase) makes the order margin-neutral, which may be usable as a counteroffer.
3. What qualitative factors and risks should the capital budgeting committee weigh before approving the manifold project, and how could the analysis be wrong?
Read the worked answer
Model risk.
- Discount rate. The 11% WACC is stated for this risk class; if the manifold line carries higher business or technology risk, a project-specific rate should be used. At 13% the NPV falls to roughly $450,000, and at about 15.5% the project's NPV reaches zero - a margin thin enough that the rate assumption is decisive.
- Revenue assumptions. Revenue is held flat for five years while costs are a constant 62% of revenue. No ramp-up, price erosion, or learning curve is modeled; a 5% revenue shortfall with costs unchanged reduces annual EBITDA by $171,000 and cuts NPV by about $450,000.
- Terminal value and salvage. Zero salvage and no residual value beyond year five may be conservative, but the equipment may also require significant maintenance in years four and five that is not in the cash costs.
- Working capital. Only $400,000 is modeled; if receivables or inventory scale with revenue, the recovery assumption is optimistic.
Strategic and qualitative factors.
- Capacity: the same idle capacity is being offered to the special-order customer, so the two decisions compete for the same floor space and labor.
- Customer relationship: the special order is from a long-standing customer; a refusal has value beyond this order, and a $70 price may set a precedent that erodes the $86 list price.
- Competitive response and pricing pressure on the manifold line; supplier concentration for the equipment; availability of skilled labor.
- Tax and accounting effects: MACRS tax depreciation exceeds book depreciation early, creating a deferred tax liability that affects reported earnings even though it does not affect NPV.
Recommendation. Approve only with a documented sensitivity range, a hurdle-rate review by risk class, and a post-implementation review process, so that the assumptions can be tested against actual results.