Question
In: Accounting
Shrieves Casting Company is considering adding a new line to its product mix, and the capital...
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 recent business school graduate.
The production line would be set up in unused space in Shrieves's main plant. The machinery's
invoice price would be approximately $200,000, another $10,000 in shipping 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 would be in Class 8 with a CCA rate of 20%. 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 1,250 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. Furthermore, to handle the new line, the
firm's net operating working capital would have to increase by an amount equal to 12%
of sales revenues. The firm's tax rate is 28%, and its overall weighted average cost of
capital is 10%.
A) 1. Construct annual incremental project operating cash flows.
2. Estimate the required net operating working capital for each year and the cash flow due to investments in net operating working capital.
3. Calculate the present value of the CCA tax shield.
B)1. What is the after-tax salvage cash flows?
2. What is the projects NPV? Should the project be undertaken?
C) 1. What is sensitivity analysis
2. Perform a sensitivity analysis on the unit sales, salvage volume, and cost of capital for the project. Assume that each of these variables can vary from its base-case, or expected, value by +/- 10% and +/- 20%. Include a sensitivity diagram, and discuss the results.
3. What is the primary weakness of sensitivity analysis? What is its primary usefulness?
D)Assume that Sidney Johnson is confident of 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 will be only 900 units a year and the unit price will be only $160; a strong consumer response will produce sales of 1,600 units and a unit price of $240. Johnson believes that there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the best case).
1.What is scenario analysis?
2.What is the worst-case NPV? The best case NPV?
3.Use the worse-, base-, and best case NPVs and probabilities of occurrence to find the projects expect NPV, standard deviation, and coefficient of variation.
E)1. Assume that Shrieves’s average project has a coefficient of variation in the range of 0.7 to 0.9. Would the new line be classified as high risk, average risk, or low risk? What type of risk is being measured here?
2. Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk. Should the new line be accepted?
3. Are there any subjective risk factors that should be considered before the final decision is made?
Solutions
Expert Solution
| Answer A | ||||
| 1.Statement of incremental Project Operating cash flows | ||||
| Cash Inflows: | ||||
| Incremental contribution after tax | 90000 | 92700 | 95481 | 98345.43 |
| 2.Incremental Net Operating Working Capital required | ||||
| Incremental sales revenue | 250000 | 257500 | 265225 | 273181.8 |
| Incremental working capital@ 12% | -30000 | -30900 | -31827 | -32781.8 |
| 3. Present value of CCA tax shield | ||||
| Year | 1 | 2 | 3 | 4 |
| Incremental Tax savings on CCA | 13440 | 10752 | 8601.6 | 6881.28 |
| Discounting factor @10% | 0.909091 | 0.826446 | 0.751315 | 0.683013 |
| Present value of cash flow | 12218.18 | 8885.95 | 6462.509 | 4700.007 |
| NPV | 32266.65 | |||
| Answer B | ||||
| 1. After tax salvage cash flows at year 4 | 18000 | |||
| 2. NPV of Project | ||||
| Year | 1 | 2 | 3 | 4 |
| Cash Inflows: | ||||
| Incremental contribution after tax | 90000 | 92700 | 95481 | 98345.43 |
| Incremental Tax savings on CCA | 13440 | 10752 | 8601.6 | 6881.28 |
| After tax salvage cash flows at year 4 | 18000 | |||
| Cash Outflows: | ||||
| Incremental working capital@ 12% | -30000 | -30900 | -31827 | -32781.8 |
| Net incremental cash flows | 73440 | 72552 | 72255.6 | 90444.9 |
| Discounting factor @10% | 0.909091 | 0.826446 | 0.751315 | 0.683013 |
| Present value of cash flow | 66763.64 | 59960.33 | 54286.7 | 61775.08 |
| Incremental NPV | 242785.8 |
Answer C
| 1. Sensitivity analysis is the method of evaluation in which we evaluate the sensitivity or change in NPV according tochange in each variable, where all other variables remain constant.. |
| 2. Sensitivity on unit sales | ||||
| If changes +/- 10% | ||||
| Year | 1 | 2 | 3 | 4 |
| Incremental Sales in units | 1375 | 1375 | 1375 | 1375 |
| Incremental cost per unit | 100 | 103.00 | 106.09 | 109.27 |
| Selling price per unit | 200 | 206.00 | 212.18 | 218.55 |
| Incremental contribution per unit | 100 | 103 | 106.09 | 109.2727 |
| Incremental sales revenue | 275000 | 283250 | 291747.5 | 300499.9 |
| Incremental contribution before tax | 137500 | 141625 | 145873.8 | 150250 |
| Tax @ 28% | 38500 | 39655 | 40844.65 | 42069.99 |
| Incremental after tax contribution | 99000 | 101970 | 105029.1 | 108180 |
| Revised NPV of Project (+10% in unit sales) | ||||
| Year | 1 | 2 | 3 | 4 |
| Cash Inflows: | ||||
| Incremental contribution after tax | 99000 | 101970 | 105029.1 | 108180 |
| Incremental Tax savings on CCA | 13440 | 10752 | 8601.6 | 6881.28 |
| After tax salvage cash flows at year 4 | 18000 | |||
| Cash Outflows: | ||||
| Incremental working capital@ 12% | -30000 | -30900 | -31827 | -32781.8 |
| Net incremental cash flows | 82440 | 81822 | 81803.7 | 100279.4 |
| Discounting factor @10% | 0.909091 | 0.826446 | 0.751315 | 0.683013 |
| Present value of cash flow | 74945.45 | 67621.49 | 61460.33 | 68492.21 |
| Incremental NPV | 272519.5 | |||
| If sales reduce by 10% | ||||
| Year | 1 | 2 | 3 | 4 |
| Incremental Sales in units | 1125 | 1125 | 1125 | 1125 |
| Incremental cost per unit | 100 | 103.00 | 106.09 | 109.27 |
| Selling price per unit | 200 | 206.00 | 212.18 | 218.55 |
| Incremental contribution per unit | 100 | 103 | 106.09 | 109.2727 |
| Incremental sales revenue | 225000 | 231750 | 238702.5 | 245863.6 |
| Incremental contribution before tax | 112500 | 115875 | 119351.3 | 122931.8 |
| Tax @ 28% | 31500 | 32445 | 33418.35 | 34420.9 |
| Incremental after tax contribution | 81000 | 83430 | 85932.9 | 88510.89 |
| Revised NPV of Project (-10% in unit sales) | ||||
| Year | 1 | 2 | 3 | 4 |
| Cash Inflows: | ||||
| Incremental contribution after tax | 81000 | 83430 | 85932.9 | 88510.89 |
| Incremental Tax savings on CCA | 13440 | 10752 | 8601.6 | 6881.28 |
| After tax salvage cash flows at year 4 | 18000 | |||
| Cash Outflows: | ||||
| Incremental working capital@ 12% | -30000 | -30900 | -31827 | -32781.8 |
| Net incremental cash flows | 64440 | 63282 | 62707.5 | 80610.36 |
| Discounting factor @10% | 0.909091 | 0.826446 | 0.751315 | 0.683013 |
| Present value of cash flow | 58581.82 | 52299.17 | 47113.07 | 55057.96 |
| Incremental NPV | 213052 | |||
| Sensitivity | %Change in NPV | 24.5% | ||
| %Change in base | 20% | |||
| Sensitivity ratio of NPV to unit sales | 122% | |||
| This means for each % change in unit sales, NPV changes by 122% | ||||
| Similarly , sensitivity can be analysed for each variable. |
Working notes:
| Cost of machinery | 240000 | |||
| CCA | 20% | |||
| Life in years | 4 | |||
| Salvage value | 25000 | |||
| Depreciation SLM | 53750 | |||
| CCA | ||||
| Year | Opening WDV | CCA at 20% | Closing WDV | Tax savings on CCA |
| 1 | 240000 | 48000 | 192000 | 13440 |
| 2 | 192000 | 38400 | 153600 | 10752 |
| 3 | 153600 | 30720 | 122880 | 8601.6 |
| 4 | 122880 | 24576 | 98304 | 6881.28 |
| Year | 1 | 2 | 3 | 4 |
| Incremental Sales in units | 1250 | 1250 | 1250 | 1250 |
| Incremental cost per unit | 100 | 103.00 | 106.09 | 109.27 |
| Selling price per unit | 200 | 206.00 | 212.18 | 218.55 |
| Incremental contribution per unit | 100 | 103 | 106.09 |
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by Sidney Johnson, a recently graduated MBA. The cost of new
machinery for the new product line would be $644,000. The machinery
has economic life of eight years, and has no salvage value. Assume
that depreciation is straight-line to zero over the life of the
machine. The new line would generate incremental sales of 70,000
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Shrieves Casting Company is considering adding a new line to its product mix, and the capital...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 cost of new
machinery for the new product line would be $644,000. The machinery
has economic life of eight years, and has no salvage value. Assume
that depreciation is straight-line to zero over the life of the
machine. The new line would generate incremental sales of 70,000
units per year at...
Shrieves Casting Company is considering adding a new line to its product mix, and the company...Shrieves Casting Company is considering adding a new line to its
product mix, and the company hires you, a recently business school
graduate, to conduct capital budgeting analysis. The production
line would be set up in unused space in Shrieves' main plant. The
machinery’s invoice price would be approximately $200,000; another
$10,000 in shipping 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 would...
Shrieves Casting Company is considering adding a new line to its product mix, and the company...Shrieves Casting Company is considering adding a new line to its
product mix, and the company hires you to conduct capital budgeting
analysis. The production line would be set up in unused space in
Shrieves' main plant. The machinery’s invoice price would be
approximately $200,000; another $10,000 in shipping 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 would
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product mix, and the company hires you, a recently business school
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line would be set up in unused space in Shrieves' main plant. The
machinery’s invoice price would be approximately $200,000; another
$10,000 in shipping charges would be required; and it would cost an
additional $30,000 to install the equipment. The machinery has an
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line would be set up in unused space in Shrieves' main plant. The
machinery’s invoice price would be approximately $200,000; another
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additional $30,000 to install the equipment. The machinery has an
economic life of 4 years, and would...
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