Time line, relevant costs, NPV and payback with taxes, uncertainties,
overconfidence Irrigation Supply is negotiating with a major hardware chain to
supply heavy–duty sprinkler heads at $18,000 each year for 6 years. Irrigation
Supply would need to retool at a cost of $20,000 to fill this order. Incremental costs
associated with the order (in addition to the retooling costs) would be $12,000 per
year. In addition, existing fixed overhead costs would be reallocated among
Irrigation Supply’s products, which would result in a $1,000 overhead charge against
the special order. For income taxes, the retooling costs would be depreciated using
the 5–year MACRS schedule. Irrigation Supply’s marginal income tax rate is 25%. The
company’s discount rate is 16%.
REQUIRED:
• A. Create a timeline showing the relevant cash flows for this problem.
• B. What is the net present value of the special order?
• C. What is the payback period for this project?
• D. For this problem, what do you learn from the NPV analysis, and what do
you learn from the payback period?
• E. The managers of the hardware store (the customers in this problem)
believe that demand will ensure their ability to purchase sprinkler heads from
Irrigation Supply. Explain why the hardware chain’s managers cannot be
certain about the future demand for sprinkler heads.
• F. Discuss how overconfidence of the managers of Irrigation Supply might
influence their investment decision
