Consider the following information about Stark Industries’ Shields Division.

Stark Industries is considering adding a vibranium shield to the Iron Man Suits the company
manufactures for the U.S. Armed Forces. The equipment to build the shields has a purchase price of
$1,275,000, and the company will spend $75,000 to ship the equipment to its plant and install it on
the production floor. Stark Industries engineers expect the machine to have a $25,000 salvage value
at the end of its 10-year life and a practical capacity of 1,200 shields per year. The new equipment
requires an average of $35,000 investment in working capital to keep the equipment running
efficiently; the $35,000 investment in working capital is fully recoverable at the end of the
investment.

Stark Industries’ current weighted average cost of capital is 16%. The estimate may vary by +/-
0.75% depending on market conditions.

Stark Industries’ negotiations with its union regarding the staffing of the new shield-manufacturing
machine resulted in the firm agreeing to hire new workers and pay them $200,000 annually. The
union agreement also stipulated that the employees have the option to request a salary revision after
the fifth year of the agreement of up to 6% of the agreed salary. Stark’s human resources department
estimates that the renegotiation with the union will result in a 3%, 4%, 5% or 6% labor cost increase
with a probability of 10%, 40%, 35% and 15%, respectively. The company also agreed to invest
$40,000 to train the new employees on the equipment when hired. Training the new employees will
be on the job, which will likely reduce the output for the first year of the project by 100 shields; in
the worst-case scenario, the decrease in output would be 25%.

Each shield consumes $500 worth of vibranium (imported from Wakanda). Recent contract
negotiations with Wakanda and King T’Challa have locked-in this cost for the next five years and
specify an increase to $525 per shield thereafter.

The current contract negotiated with the U.S. Armed Forces guarantees a price of $1,000 per shield
for the first 5 years in the contract. Tony Stark, Stark Industries’ CEO, believes it is unlikely the
government will require a reduction of more than 20% of the price per shield in the next contract
negotiation. Exhibit 1 indicates Tony’s assessment of the revised contract prices with their estimated
probabilities of realization.

Common practice in the tax department of Stark Industries is to depreciate the full value of any
acquired assets regardless of their salvage values. Pepper Potts (Stark Industries CFO) determined

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the equipment is 7-years class property (see depreciation percentages for this type of property in
Exhibit 2). Stark Industries is subject to a 26% tax rate (21% corporate tax rate plus 5% blended rate
of state taxes).

Exhibit 1: Government Contract Renegotiation Estimates:

RENEGOTIATIED
PRICE PROBABILITY
1,000 5%
950 15%
900 30%
850 30%
800 20%

Exhibit 2: Depreciation Schedule (in percentages) for 7-year property.

1 14.29
2 24.49
3 17.49
4 12.49
5 8.93
6 8.92
7 8.93
8 4.46

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Required (Please, provide supporting schedules for all your answers):
I. [50 points] Determine the NPV of the project. Clearly state the assumptions for your
calculations. (Hint: since your will be evaluating more than one scenario, it will be on your best interest to
use formulas and cell references in your Excel worksheets. This is a good opportunity to practice your
worksheet modeling skills.)

II. [20 points] Using the information on the project and the assumptions you made in part I
indicate the following:
a. [5 points] What is the Internal Rate of Return of the project?
b. [5 points] What is the after-tax payback period of the project?
c. [5 points] How sensitive is the viability of the project to the choice hurdle rate
assumptions you made part I? (Indicate the NPV for each of the alternative hurdle
rates you use).
d. [5 points] What will be the lowest price that Stark Industries may be able to accept
upon contract renegotiation in year 5 that would continue to make (or would make)
the project viable (i.e., the NPV = 0)?

III. [10 points] Assume that Ms. Potts suggests that the company may be able to use Section 179
of the Internal Revenue Code, which allows the company to expense up to $1,000,000 of the
cost of an asset in the year it is placed into service. The remaining asset cost would be
depreciated using the 7-year class depreciation table starting in the year it is placed in service.
a. [5 points] What would be the NPV of the project if Stark Industries were able to take
the full benefit of Section 179?
b. [5 points] What would be the Internal Rate of Return based on this scenario?

IV. [25 points] Sensitivity analysis.

a. [20 points] In addition to the scenarios calculated above, calculate the NPV under
the most optimistic set of assumptions and the most pessimistic set of assumptions
and summarize the NPV and IRR calculation for each scenario. (For this requirement,
you must combine the best and worst possible scenarios given all the information included in the
case.) Please be explicit about your assumptions for each scenario.
b. [5 points] Briefly, comment on the importance of conducting sensitivity analysis
when evaluating long-term capital investments.

V. [15 points] Based on the data you have obtained throughout the exercise, would you
recommend Stark Industries to accept the project? Write a short memo to Mr. Tony Stark
Indicating your recommendation.

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