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 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) 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.

Answer 1

a)

11. Both interest expense and dividend should be subtracted to calculate project cashflow.

2. Yes, it should be included under capital expenditure.

3. Yes, it should be subtracted from the annual revenue each year.

4. Yes, it should be subtracted from the annual revenue each year.

(b)

It is important to consider the inflation as it would impact the per unit seeling price and cost, which would eventually result in increase of both revenue and cost due to inflation.

(c)

working