Shrieves Casting Company is considering adding a new line to its product mix, an
ID: 2615890 • Letter: S
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 1096.Explanation / Answer
Cost of Machinery:
Machinery Invoice = $ 200,000
(+) Shipping Charges = $ 10,000
(+) Additional expenses = $ 30,000
= $ 240,000
Salvage value = $ 25,000
Life of the Asset = 4 years
As we are given in the question the Depreciable basis is MACRS and the asset is permissable in 3 year class. According to MACRS (3 year) depreciation the following are the percentage to be considered while calculating depreciation:
1st year = 33.33% 2nd year = 44.45% 3rd = 14.81% 4th = 7.41%
So, the depreciation expenses for the four years are as follows:
Year 1 (240,000 - 25,000) * 33.33% = $ 71,666.67
Year 2 (240,000 - 25,000) * 44.45% = $ 95,567.50
Year 3 (240,000 - 25,000) * 14.81% = $ 31,841.50
Year 4 (240,000 - 25,000) * 7.41% = $ 15.924.33
Inflation is important to consider because we have keep an eye on the future cash flows. Inflation is directly related to the Time value of money so to tackle with that problem we should take inflation into consideration and better be prepared.
Calculation of Annual Sales Revenue and Costs (Incremental) Year 1 Year 2 Year 3 Year 4 Units Sold 1,250 2,500 3,750 5,000 Sale price per unit 200 206 212.18 218.55 Sale Revenue $ 250,000.00 $ 515,000.00 $ 795,675.00 $ 1,092,750.00 Cost per unit 100 103 106.1 109.27 Cost 125000 257500 397875 546350 Increase in Net Working Capital (12% of Revenue) 30000 61800 95481 131130 Total Cost $ 155,000.00 $ 319,300.00 $ 493,356.00 $ 677,480.00Related Questions
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