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John Crockett Furniture Company is considering adding a new line to its product mix
and that the capital budgeting analysis is being conducted by Joan Samuels, a recently
graduated MBA. The production line would be set up in unused space in Crockett’s
main plant. The machinery’s invoice price would be approximately $200000, another
$10000 in shipping charges would be required and it would cost an additional $30000
to install the equipment. The machinery has an economic life of 4 years and
depreciation is charged on straight line method. The machinery is expected to have a
salvage value of $25000.

The new line would generate incremental sales of 1250 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 sale price and the cost are both expected to increase by
3% per year due to inflation. Further, to handle the new line, the firm’s net working capital
is expected to be 12% of sales. Working capital level is adjusted at the beginning of the
year in relation to the sales expected for the year. At the end of the useful life, working
capital will be liquidated. The firm’s tax rate is 30% and the cost of capital is 10%.

a. Estimate the cash flows for the project distinctly showing the initial cash flows,
operating cash flows and terminal cash flows

b. Calculate the NPV and the IRR for the project.

c. How will you deal with the following situations while estimating cash flows
i. Assume that the plant space could be leased out to another firm @$25000 per
year, should this be considered in your analysis?
ii. How will you treat with interest expenses and dividends when calculating
project cash flows?
iii. Finally, assume that the new product line is expected to decrease the sales of
the firm’s other lines by $50000, should this be considered in your analysis, if
so, how?

Assume that Joan Samuels is confident of her estimates of all the variables that affect the
project’s cash flows except for unit sales and sales price. If product acceptance is poor, unit
sales will be 900 units a year and the unit price would be $160; a strong consumer response
would produce sales of 1600 units and a unit price of $240. Construct a scenario analysis for
the poor acceptance and excellent acceptance and determine the NPV for the scenarios.
Ignore the salvage value and working capital requirements while estimating cash flows in this
case. Joan believes that there is a 25% chance of poor acceptance, 25% chance of excellent
acceptance and 50% chance of average acceptance (base case of 1250 units). What will be the
project’s expected NPV, standard deviation and coefficient of variation?