Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 14

Sensitivity Analysis in Capital Investment Decisions

Square Manufacturing is considering investing in a robotics manufacturing line. Installation of the line will cost an estimated $4.5 million. This amount must be paid immediately even though construction will take three years to complete (years 0, 1, and 2). Year 3 will be spent testing the production line and, hence, it will not yield any positive cash flows. If the operation is very successful, the company can expect after-tax cash savings of $3 million per year in each of years 4 through 7. After reviewing the use of these systems with the management of other companies, Square’s controller has concluded that the operation will most probably result in annual savings of $2,100,000 per year for each of years 4 through 7. However, it is entirely possible that the savings could be as low as $900,000 per year for each of years 4 through 7. The company uses a 14 percent discount rate.

Required

Compute the NPV under the three scenarios.

Step 1 of 9

Capital budgeting

Capital budgeting is the process used by the company to evaluate the capital investment that are available. The company uses various capital budgeting methods to evaluate whether the company should invest in the project that is whether the project is profitable for the company.