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 recent business school graduate.

The production line would be set up in unused space in Shrieves'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. The machinery has

an economic life of 4 years and would be in Class 8 with a CCA rate of 20%. 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. Furthermore, to handle the new line, the

firm's net operating working capital would have to increase by an amount equal to 12%

of sales revenues. The firm's tax rate is 28%, and its overall weighted average cost of

capital is 10%.

A) 1. Construct annual incremental project operating cash flows.

2. Estimate the required net operating working capital for each year and the cash flow due to investments in net operating working capital.

3. Calculate the present value of the CCA tax shield.

B)1. What is the after-tax salvage cash flows?

2. What is the projects NPV? Should the project be undertaken?

C) 1. What is sensitivity analysis

2. Perform a sensitivity analysis on the unit sales, salvage volume, and cost of capital for the project. Assume that each of these variables can vary from its base-case, or expected, value by +/- 10% and +/- 20%. Include a sensitivity diagram, and discuss the results.

3. What is the primary weakness of sensitivity analysis? What is its primary usefulness?

D)Assume that Sidney Johnson is confident of her estimates of all the variables that affect the projects cash flows except unit sales and sales price. If product acceptance is poor, unit sales will be only 900 units a year and the unit price will be only $160; a strong consumer response will produce sales of 1,600 units and a unit price of $240. Johnson believes that there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the best case).

1.What is scenario analysis?

2.What is the worst-case NPV? The best case NPV?

3.Use the worse-, base-, and best case NPVs and probabilities of occurrence to find the projects expect NPV, standard deviation, and coefficient of variation.

E)1. Assume that Shrievess average project has a coefficient of variation in the range of 0.7 to 0.9. 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?