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 machinerys 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 1,000 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 firms net working capital would have to increase by an amount equal to 12% of sales revenues. The firms 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 firms other lines by $50,000 per year. Should this be considered in the analysis? If so, how?

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

c. Calculate annual net operating profit after sales (NOPAT). Then calculate the operating cash flows.

d. 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?