John Crockett Furniture Company is considering adding a new line to its product mix, and the capital

budgeting analysis is being conducted by Joan Samuel, a recently graduated finance MBA. The production line would

be set up in unused space in Crockett$$s main plant. The machinery$$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. Further, the firm$$s inventories would have to be increased by $$25,000$ to handle the new line, but its

accounts payable would rise by $$5,000.$ The machinery has an economic life of $4$ years, and Crockett 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 $$25,000$ after $4$ years of use. The new line would generate $$125,000$ in incremental net revenues

$($before taxes and excluding depreciation$)$ in each of the next $4$ years. The firm$$s tax rate is $40\%,$ and its overall

weighted average cost of capital is $10\%.$

a$.$ Construct the project$$s cash flows over its four$-$year life. Based on these cash flows, what are the project$$s

NPV and IRR? Do these indicators suggest that the project should be undertaken?

b$.$ Assume now that the project is a replacement project rather than a new, or expansion, project. Describe

how the analysis would differ for a replacement project.

c$.$ Explain what is meant by cash flow estimation bias. What are some steps that Crockett$$s management

could take to eliminate the incentives for bias in the decision process?

d$.$ In an unrelated analysis, Joan was asked to choose between the following two mutually exclusive projects:

Expected Net Cash Flow

Year Project S Project L

$0-$$$100,000-$$$100,000$

$160,00033,500$

$260,00033,500$

$333,500$

$433,500$

The project provides a necessary service, so whichever one is selected is expected to be repeated into the

foreseeable future. Both projects have a $10\%$ cost of capital.

$(1)(2$ points$)$ What is each project$$s initial NPV without replication? Can you use the information to determine

which project should be chosen? Explain.

$(2)(2$ points$)$ Now apply the replacement chain approach to determine the projects$$ extended NPVs$.$ Which project

should be chosen? Explain.

$(3)(2$ points$)$ Repeat the analysis using the equivalent annual annuity approach. Which project should be chosen?

Explain.

$(4)(2$ points$)$ Now assume that the cost to replicate Project S in two years will increase to $$105,000$ because of

inflationary pressures. How should the analysis be handled now, and which project should be chosen? Explain.