Case study 1:
Shrieves Casting Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Sidney Johnson, a recently gradu-ated MBA. The production line would be set up in unused space in the main plant. The machinery’s invoice price would be approximately $200,000, another $10,000 in ship-ping charges would be required, and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 4 years, and Shrieves has obtained a special tax ruling that places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $25,000 after 4 years of use. The new line would generate incremental sales of 1,000 units per year for 4 years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are both expected to increase by 3% per year due to inflation. Further, to handle the new line, the firm’s net working capital would have to increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 25%, and its overall weighted average cost of capital, which is the risk-adjusted cost of capital for an average project (r), is 10%.
a. Define “incremental cash flow.”
b. The projected cash flows for the company with the project minus the projected cash flows for the company without the
c. project.
d. The projected cash flows for the company with the project minus the projected cash flows for the company without the
e. project.
f. The projected cash flows for the company with the project minus the projected cash flows for the company without the
g. project.
h. The projected cash flows for the company with the project minus the projected cash flows for the company without the
i. project.
The projected cash flows for the company with the project minus the projected cash flows for the company without the project.
(1) Should you subtract interest expense or dividends when calculating project cash flow? No, you should not subtract interest expense or dividends when calculating the project cash flow because the intrest and dividends are already included in the project’s weighted average of the costs of debt (WACC), in other words subtracting the interest and dividends would result in double counting interest costs.
(2) Suppose the firm spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain.
No, because this is a sunk cost, meaning this is a cost that was incurred in the past and cannot be recovered regardless of whether the project is accepted. (3) Now assume the plant space could be leased out to another firm at $25,000 per year. Should this be included in the analysis? If so, how?
Yes, by accepting the project the company will not receive the $25,000 per year for leasing the plant space, so this is an opportunity cost. (4) Finally, assume that the new product line is expected to decrease sales of the firm’s other lines by $50,000 per year. Should this be considered in the analysis? If so, how?
Yes, this is considered an externality. Externalities are the effects of a project on other parts of the firm or on the environment. A decrease in sales of other product lines is a negative externality and should be considered a cost to the project b. Disregard the assumptions in Part a. What is the depreciable basis? What are the an-nual depreciation expenses? c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows? d. Calculate annual net operating profit after sales (NOPAT). Then calculate the operating cash flows.
e.Estimate the required net operating working capital (NOWC) for each year and the cash flow due to changes in NOWC. f. Calculate the after-tax salvage cash flow. g. Calculate the project cash flows for each year. Based on these cash flows and the average project cost of capital, what are the project’s NPV, IRR, MIRR, PI, payback, and discounted payback? Do these indicators suggest that the project should be undertaken?