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 1,250 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. 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 40%, 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: is the additional operating cash flow that an organization receives from taking on a new project. If incremental cash flow is positive the companys cash flow will increase with the acceptance of the project.

(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.

Since the expense was incurred last year and not directly related to the project, you can consider this as a sunk cost. And all sunk costs are ignored in capital budgeting.

(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

f. Calculate the after-tax salvage cash flow.

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?