Solved: Shrieves Casting Company is considering adding a

new line to

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 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 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 firm's net working
capital would have to increase by an amount equal to 12% of sales revenues. The firm's 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."

(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 firm's other
lines by $50,000 per year. Should this be considered in the analysis? If so, how?

b. Disregard the assumptions in Part a. What is the depreciable basis? What are the annual
depreciation expenses?

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

d. Construct annual incremental operating cash flow statements.

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

f. Calculate the after-tax salvage cash flow.

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g. Calculate the net cash flows for each year. Based on these cash flows and the average
project cost of capital, what are the project's NPV, IRR, MIRR, PI, payback, and discounted
payback? Do these indicators suggest that the project should be undertaken?

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?

i. (1) What are the three types of risk that are relevant in capital budgeting?

(2) How is each of these risk types measured, and how do they relate to one another?

(3) How is each type of risk used in the capital budgeting process?

j. (1) What is sensitivity analysis?

(2) Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the
project. Assume each of these variables can vary from its base-case, or expected, value by
±10%, ±20%, and ±30%. Include a sensitivity diagram, and discuss the results.

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

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

(1) What is scenario analysis?

(2) What is the worst-case NPV? The best-case NPV?

(3) Use the worst-, base-, and best-case NPVs and probabilities of occurrence to find the
project's expected NPV, as well as the NPV's standard deviation and coefficient of variation.

l. Are there problems with scenario analysis? Define simulation analysis, and discuss its
principal advantages and disadvantages.

m. (1) Assume the company's average project has a coefficient of variation in the range of 0.2 to
0.4.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?
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 n. What is a real option? What are some types of real options?

Shrieves Casting Company is considering adding a new line to

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