Project Cash Flows for a Cost-Only Project. Alcoa Aluminum’s McCook plant produces aluminum coils, sheets, and plates. Its annual production runs at 400 million pounds. In an effort to improve McCook’s current production system, an engineering team led by the divisional vice president

Question

Project Cash Flows for a Cost-Only Project

Alcoa Aluminum’s McCook plant produces aluminum coils, sheets, and plates. Its annual production runs at 400 million pounds. In an effort to improve McCook’s current production system, an engineering team led by the divisional vice president went on a fact-finding tour of Japanese aluminum and steel companies to observe their production systems and methods. Cited among the team’s observations were large fans, which the Japanese companies used to reduce the time that coils need to cool down after various processing operations. Cooling the hot process coils with the fans was estimated to significantly reduce the queue or work-in-process (WIP) inventory buildup allowed for cooling. The approach also reduced production lead-time and improved delivery performance. The possibility of reducing production time and, as a consequence, the WIP inventory, excited the team members, particularly the vice president. After the trip, Neal Donaldson, the plant engineer, was asked to investigate the economic feasibility of installing cooling fans at the McCook plant. Neal’s job was to justify the purchase of cooling fans for his plant. He was given one week to prove that the idea was a good one. Essentially, all he knew was the number of fans, their locations, and the project cost. Everything else was left to Neal’s devices. Suppose that he compiled the following financial data.

The project will require an investment of $536,000 in cooling fans now.
The cooling fans would provide 16 years of service with no appreciable salvage values, considering the removal costs.
It is expected that the amount of time required between hot rolling and the next operation would be reduced from five days to two days. Cold-rolling queue time also would be reduced from two days to one day for each cold-roll pass. The net effect of these changes would be a reduction in the WIP inventory at a value of $2,121,000. Because of the lead-time involved in installing the fans, as well as the consumption of stockpiled WIP inventory, this working-capital release would be realized one year after the fans are installed.
The cooling fans will be depreciated according to seven-year MACRS.
Annual electricity costs are estimated to rise by $86,000.
The firm’s after-tax required rate of return is known to be 20% for this type of cost-reduction project.

Develop the project cash flows over the service period of the fans, and determine whether the investment is a wise one, based on 20% interest and 40% marginal tax rate.

Accepted Answer

Given: Required investment = $536,000, service period = 16 years, salvage value = $0, depreciation method for cooling fans = 7 - year MACRS, working-capital release = $2,121,000 one year later, annual operating cost (electricity) = $86,000, [latex]t_{m}[/latex]= 40%, and MARR = 20%.
Find: (a) Annual after-tax cash flows, (b) the investment decision on the basis of the NPW, and (c) the investment decision on the basis of the IRR.

(a) Because we can assume that the annual revenues would stay the same as they were before and after the installation of the cooling fans, we can treat these unknown revenue figures as zero. Table 10.7 summarizes the cash flow statement for the cooling-fan project. With no revenue to offset the expenses, the taxable income will be negative, resulting in tax savings. Note that the working-capital recovery (as opposed to working-capital investment for a typical investment project) is shown in year 1. Note also that there is no gains tax, because the cooling fans are fully depreciated with a zero salvage value.

(b) At i = 20%, the NPW of this investment would be

PW(20%) = -$536,000 + $2,100,038(P/F, 20%, 1)
+$906(P/F, 20%, 2) + ...
-$2,172,600(P/F, 20%, 16)
= $991,008

Even with only a one-time savings in WIP, this cooling-fan project is economically justifiable.

(c) If we are to justify the investment on the basis of the internal rate of return, we first need to determine whether the investment is a simple or complex one. Since there are several sign changes in the cash flow series, this is not a simple investment, indicating the possibility of multiple rates of return. In fact, as shown in Figure 10.6, the project has two rates of return, one at 4.24% and the other at 291.56%. Neither is a true rate of return, as we learned in Section 7.3.2, so we may proceed to abandon the rate-of-return approach and use the NPW criterion. If you desire to find the true IRR for this project, you need to follow the procedures outlined in Section 7.3.4. At a MARR of 20%, the true IRR (or return on invested capital) is 241.87%, which is significantly larger than the MARR and indicates acceptance of the investment. Note that this is the same conclusion that we reached in part (b).

Comments: As the cooling fans reach the end of their service lives, we need to add the working-capital investment ($2,120,000) at the end of year 16, working under the assumption that the plant will return to the former system without the cooling fans and thus will require the additional investment in working capital.

If the new system has proven to be effective and the plant would remain in service, we need to make another investment to purchase a new set of cooling fans at the end of year 16. As a consequence of this new investment, there will be a working-capital release in the amount of $2,120,000. However, this investment should bring benefits to the second cycle of the operation, so that it should be charged against the cash flows for the second cycle, not the first cycle.

Question 10.5: Project Cash Flows for a Cost-Only Project. Alcoa Aluminum’s...

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