Shrieves Casting Company is considering adding a new line to its product mix, an

Question

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 equip- ment. 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 (2) Suppose the firm spent $100,000 last year to rehabilitate the production line site ) Now assume the plant space could be leased out to another firm at $25,000 per (4) Finally, assume that the new product line is expected to decrease sales of the firm's flow? Should this be included in the analysis? Explain. year. Should this be included in the analysis? If so, how? other lines by $50,000 per year. Should this be considered in the analysis? If so, how?

Explanation / Answer

If Company has taken a loan to buy the equipment, Yes it has to subtract the interest expense first from the projected cash flow, as General Creditors gets the first claim.

2) IF $100,000 has been spent to rehabilitate the production line, this has to be included in the analysis as even the rehabilitation of the production line is the part of the process to increase the cash flow.

3) This can be included in the analysis as Opputunity cost, that is if the current project is not setted up on that land the company might get $25,000, now they need to analyze if the project benefit (net profit form project) is greater than the opportunity cost or not, if not they may cancel the project.

4) Yes, this can be added as overall profitability of the firm is being decreased by $50,000, therefore profit generated from the new profit line should be more than the decreased value.

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