Question

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 graduated MBA. The production line would be set up in unused space in Shrieves’ main plant. The machinery would incur $10,000 in shipping charges, and it would cost an additional $28,000 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 3­year class. The machinery is expected to have a salvage value of  15% of initial outlay after 4 years of use.

The new line would generate incremental unit sales per year for 4 years at an incremental cost of $108 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 35%, and its overall weighted average cost of capital is 10%.

	Group 1	Group 2	Group 3	Group 4	Group 5
Invoice price					410,000
Unit sales					2,500
Poor acceptance					2,000
Strong acceptance					3,000

1. Construct annual incremental operating cashflow statements.
2. Estimate the required net working capital for each year and the cash flow due to investments in net working capital.
3. Calculate the after­tax salvage cash flow.
4. Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR, MIRR, PI, payback, and discounted payback? Do these indicators suggest that the project should be undertaken?
5. What does the term “risk” mean in the context of capital budgeting; to what extent can risk be quantified; and, when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates?
6. Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the project. Assume each of these variables can vary from its base­case, or expected, value by +/-10%, +/-20%, and +/-30%.
   1. Include a sensitivity diagram, and discuss the results.
7. Assume that Sidney Johnson is confident in her estimates of all the variables that affect the project’s cash flows except unit sales and sales price. If product acceptance is poor, unit sales would be as in the table and the unit price would only be $160; a strong consumer response would produce sales as in the table and a unit price of $240. Johnson believes there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case).
   1. What is the worst­case NPV? The best­case NPV?
   2. Use the worst­, base­, and best­case NPVs and probabilities of occurrence to find the project’s expected NPV, as well as the NPV’s standard deviation and coefficient of variation.
8. Shrieves typically adds or subtracts 3 percent­ age points to the overall cost of capital to ad­ just for risk. Should the new line be accepted?

Answer 1

Year	0	1	2	3	4
1.Initial cost	-410000
2.Shipping	-10000
3.Installation	-28000
4.After-tax salvage(448000*15%*(1-35%))					43680	(ANSWER:c)
a. Annual incremental Opg. Cash flows:
5.Sales(2500*200)g=3%/yr.		500000	515000	530450	546363.5
6.Costs(2500*108)g=3%/yr.		-270000	-278100	-286443	-295036
7.MACRS dep.(33.33,44.45,14.81&7.41%)		-149318	-199136	-66348.8	-33196.8
8.EBT(5+6+7)		80681.6	37764	177658.2	218130.4
9.Tax at 35%(8*35%)		-28238.6	-13217.4	-62180.4	-76345.6
10.EAT(8+9)		52443.04	24546.6	115477.8	141784.8
11.Add back: Dep.(Row 7)		149318.4	199136	66348.8	33196.8
12.Annual incremental Opg. Cash flows:		201761.4	223682.6	181826.6	174981.6	(ANSWER:a)
NWC reqd.(sales*12%)	60000	61800	63654	65564	0
13.Change in NWC	-60000	-1800	-1854	-1910	65564	(ANSWER:b)
14.FCFs(1+2+3+4+12+13)	-508000	199961.4	221828.6	179917	284225.2
15.PV F at 10%(1/1.1^Yr.n)	1	0.90909	0.82645	0.75131	0.68301
16.PV at 10%(14*15)	-508000	181783.1	183329.4	135174.3	194129.6
17.NPV at 10%(Sum of Row 14)	186416
18.IRR(of row 14)	25%
19.MIRR(of row 14)	19%
20.PI= 1+(NPV/Initial Inv.)
ie.1+(186416/508000)=
1.37
Disc.P/B
16.PV at 10%(14*15)	-508000	181783	183329	135174	194130
Cumulative disc.PVs	-508000	-326217	-142887	-7713	186416
3+(7713/194130)=
3.04
Years
d..Conclusion:
YES. The project can be undertaken, as
NPV of the cash flows is POSITIVE
IRR,25% > WACC, 10%
MIRR, 19 % > WACC, 10%
Disc.P/B (3.04 yrs.) is within its life of 4 yrs.
PI , 1.37 > 1

e. Risk in capital budgeting projects is the uncertainty of both cash inflows & outflows, decreasing /increasing , throwing off-balance , the estimations. These may be due to decrease in demand for the products,or changes in any of the cost components , from that which was forecasted.

Even though we may not be able to forecast the exact increase /decrease,we can mitigate this issue, by running scenario & sensitivity analysis , on the projected base case flows .

So, it is a case of both quantification based primarily on statistical analysis of historical data and subjective, judgmental estimates.

The base case is projection based on historical data &

the scenario & sensitivity analysis , on the base case , are based on "what if" judgement .

Sensitivity	Sales	Salvage value	COGS	COC
10%	233825	189400	128436	170968
-10%	139008	183433	244397	202441
20%	281234	192383	70455	156069
-20%	91599	180450	302378	219070
30%	328643	195367	12474
-30%	44190	177476	360359