Iron Ore What? (IOW) Casting Company is considering adding a new line to its pro

Question

Iron Ore What? (IOW) Casting Company is considering adding a new line to its product mix. Sydney Johnson, a recently minted MBA, will be conducting the capital budgeting analysis. The new production line would be set up in unused space in IOW’s main plant. The machinery invoice price totals approximately $250,000, with another $20,000 in shipping charges and $30,000 to install the equipment, for a total requirement estimated at $300,000. The machinery has an economic life of 4 years, and IOW has obtained a special tax ruling that places the equipment in the Modified Accelerated Cost Recovery System (MACRS) 3-year class. After 4 years of use the machinery is expected to have a salvage value of $25,000. The new product line would generate incremental sales of 1,350 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 each in the first year. The sales price and cost are 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 15% of sales revenues. The firm’s tax rate is 40%, and its overall weighted average cost of capital is 12%.

1. What are the project’s NPV, IRR, MIRR, PI, payback, and discounted payback? Do these indicators suggest the project should be undertaken? Explain.

2. 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? Provide your rationale.

3. Describes sensitivity analysis and discuss a) its primary weakness; and b) its primary usefulness? For the IOW project, perform a sensitivity analysis on the unit sales, salvage value, and cost of capital. Assume that each of these variables can vary from its expected, or “base-case” value by ± 10%, ± 20%, and ± 30%. Include a sensitivity diagram, and discuss the results.

4. Assume that Sydney Johnson is confident of 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 could be only approximately 1,000 units a year and the unit price would be set at $150. Conversely, an excellent consumer response could produce sales of 2,000 units and a unit price of $220. Sidney believes that there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case). What is the worst-case NPV? The best-case NPV? Use the worst-, base-, and best-case NPVs and probabilities of occurrence to find the project’s expected NPV, standard deviation, and coefficient of variation.

5. Explain scenario analysis and any problems, issues, or concerns that surround this type of projection.

6. Define simulation analysis, and discuss its principal advantages and disadvantages.

7. Assume that IOW’s average project has a coefficient of variation in the range of 0.2 to 0.4. Would the new product line be classified as high risk, average risk, or low risk? What type of risk is being measured here?

8. IOW typically adds or subtracts 5 percentage points to the overall cost of capital to adjust for risk. Given this consideration, should the new line be accepted? Explain.

9. Describe other subjective risk factors that should be considered before the final decision is made, and their individual impact on the project.

Explanation / Answer

Answer :-

Investment = 250000 + 20000 + 30000

= $ 300000

Life = 4 years

Scrap value = 25000

Depreciation = (300000 - 25000) / 4

= 68750

(206*1350*15%)

=41715

(212.18*1350*15%)

=42966

(218.55*1350*15%)

=44256

NPV = Present value - Investment

= 263768 - 300000

= - 36232 (negative)

Years 1 2 3 4 Selling Price 200 200*(1.03)1 = 206 200*(1.03)2 = 212.18 200*(1.03)3 = 218.55 less:- Cost 100 100*(1.03)1 = 103 100*(1.03)2 = 106.09 100*(1.03)3 = 109.27 Net Price 100 103 106.09 109.28 Units 1350 1350 1350 1350 EBIT befor depreciation 135000 139050 143222 147528 less:- Depreciation 68750 68750 68750 68750 EBIT (earning before interest & tax) 66250 70300 74472 78778 less:- Tax @ 40% 26500 28120 29789 31511 NOPAT(net operating profit after tax) 39750 42180 44683 47267 add:- Depreciation 68750 68750 68750 68750 less:- working capital 0

(206*1350*15%)

=41715

(212.18*1350*15%)

=42966

(218.55*1350*15%)

=44256

add :- scrap value 25000 Free Cash Flow 108500 69215 70467 96761 PVIF at 12% .893 .797 .712 .636 Present Value 96891 55164 50173 61540 TOTAL Present Value 263768

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