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 the 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 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 1,00 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.”
(1) Should you subtract interest expense or dividends when calculating project cash flow?
(2) Suppose the firm spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain.
(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?
(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?
b. Disregard the assumptions in Part a. What is the depreciable basis? What are the annual 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 project recurring 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?
h. 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?
i. (1) What are the three types of risk that are relevant in capital budgeting?
(2) How is each of these risk types measured, and how do they relate to one another?
(3) How is each type of risk used in the capital budgeting process?
j. (1) What is sensitivity analysis?
(2) Perform a sensitivity analysis on the cost per unit, unit sales, and salvage value. Assume each of these variables can vary from its basecase, or expected, value by plus or minus 10%, 20%, and 30%. Include a sensitivity graph, and discuss the results.
(3) What is the primary weakness of sensitivity analysis? What is its primary usefulness?
k. 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 would be only 800 units a year and the unit price would only be $160; a strong consumer response would produce sales of 1,200 units and a unit price of $240.
Sidney believes that 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 scenario analysis?
(2) What is the worst-case NPV? The best-case NPV?
(3) Use the worst-, base-, and best-case NPVs and probabilities of occurrence to find the project’s expected NPV, as well as the NPV’s standard deviation and coefficient of variation.
l. Are there problems with scenario analysis? Define simulation analysis, and discuss its principal advantages and disadvantages.
m. (1) Assume the company’s average project has a coefficient of variation in the range of 0.2 to 0.4. 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?
n. What is a real option? What are some types of real options?