is considering adding a new line to its product mix. The production line would be set up in unused space in Shrivers main plant. The machinerys invoice price would be approximately $200,000, another $10,000 in shipping charges would be required, and it would cost additional $30,000 to install the equipment. The machinery has an economic life of 4 years, and Shrives 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 1,250 units per year for 4 year at an incremental cost of $100 pr 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. The firms net working capital will have to increase by 12% of sales revenues. The firms tax rate is 40%, and its overall weighted average cost of capital is 10%.

Define incremental cash flow

Should you subtract interest expense or dividends when calculating project cash flow?

Suppose the firm spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain.

Now assume the plant space could be leased out to another firm at $25,000 per year. Should his be included in the analysis? If so, how?

Assume that the new product line is expected to decrease sales of the firms other lines by $50,000 per year. Should this be considered in the analysis? If so, how?

Calculate the annual sales revenues and costs (other than depreciation). Why is this important to include inflation when estimating cash flow?

Calculate the net cash flows for each year. Based on those cash flows, what are the projects NPV, IRR, MIRR, PI, payback, and discounted payback? Do these indicators suggest that the project should be undertaken?

What does the term risk mean I 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 estimate?

a) Assume Shrivers 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?

b) Shrives typically ads or subtracts 3 percentage points to the overall cost of capital to adjust for risk. Should the new line be accepted?

c) Are there any subjective risk factors that should be considered before the final decision is made?