Titan Casting Company

Titan Casting Company is conSiddhering adding a new line to its product mix, and the capital budgeting analysis is being completed by Siddh Johnson, a recent MBA graduate. The production line for the new product would be set up in unused space in the main plant. The production machinery needed for the project will cost $300,000, another $10,000 in shipping charges would be required, and it would cost an additional $30,000 to install the equipment. The shipping and set-up costs will be written off for tax purposes immediately. The equipment has an economic life of four years, Mr. Johnson has obtained a special tax ruling that places the equipment in the MACRS 3-year class. The machine is expected to have a salvage value of $25,000 after four years of use.

The new line is expected to generate incremental sales for four years. Siddh believes that there is a high amount of uncertainty about the levels of sales though. He believes there is a 40 percent chance that sales will be only 1,000 units and 60 percent chance that sales will be at least 1,500 units in each of the four years. He estimates that the unit sales price will be $200 in the first two years and $300 in the last two years and that cost of goods sold, excluding depreciation expense, will be constant at $150 per unit. He expects that inflation will not be an issue in the next four years as the general economy is expected to be very weak.

The net working capital investment for the new line is estimated at 10 percent of sales. All working capital invested will be recovered at the end of the projects life. The companys tax rate is 20 percent and its weighted average cost of capital for this project is 10 percent.

Siddh has identified several features of the new project that he is not sure how to handle. The first issue is that the company invested $5,000 last year in collecting marketing information about the new product. This expenditure was very important to gaining an understanding of the product market and would not have been made except to understand its potential. The company also spent $10,000 putting a new roof on the part of the main plant where the new product line will be.

Additionally, Siddh believes that as a result of having the new product line, there will be a 4 percent increase in sales of existing products. Each 1 percent increase in sales of existing products translates into a change in Before tax operating profit for Titan Casting Company of $2,000. He believes that this expected impact will materialize for each year of the new products life

Finally, the plant manager of the main plant told Siddh that he had received an offer from a local small business to lease the space where the new product line could be. The plant manager indicated that the annual lease payment that the small business was willing to pay was $20,000 per year before taxes. Finally, the plant accountant told Siddh that he would charge a General Factory Expense to the new project that would be $3,000 per year and that the project would get charged an interest expense equal to 10 percent of the original invoice price for the equipment which had been $300,000.

>MACRS-3yrs

1. .333
2. .444
3. .148
4. .074

Should Titan Casting make the necessary investment to start the new line?