I have a homework assignment that I am completely drawing a blank on. Any help w
ID: 2733207 • Letter: I
Question
I have a homework assignment that I am completely drawing a blank on. Any help would be greatly appreciated!! 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. Calculate and provide the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows? 2. Construct 4 years of annual incremental operating cash flow statements for IOW Casting Company. Estimate the required net working capital for each year, and the cash flow due to investments in net working capital. Calculate the after-tax salvage cash flow. 3. Calculate the net cash flows for each of the 4 years. Based on these cash flows, what are the project’s NPV, IRR, MIRR, PI, payback, and discounted payback? Do these indicators suggest the project should be undertaken? Explain. 4. 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. 5. 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.
Explanation / Answer
Calculate and provide the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows?
Answer: With an inflation rate of 3%, the annual revenues and costs are:
The cost of capital is a nominal cost; i.e., it includes a premium for inflation. In other words, it is larger than the real cost of capital. Similarly, nominal cash flows (those that are inflated) are larger than real cash flows. If you discount the low, real cash flows with the high, nominal rate, then the resulting NPV is too low. Therefore, you should always discount nominal cash flows with a nominal rate, and real cash flows with a real rate. In theory, you could do either way and get the correct answer. However, there is no accurate way to convert a nominal cost of capital to a real cost. Therefore, you should inflate cash flows and then discount at the nominal rate.
Construct 4 years of annual incremental operating cash flow statements for IOW Casting Company.
Answer:
Estimate the required net working capital for each year, and the cash flow due to investments in net working capital. Calculate the after-tax salvage cash flow.
Answer: The project requires a level of net operating working capital in the amount equal to 15% of the next year’s sales. Any increase in NOWC is a negative cash flow, and any decrease is a positive cash flow.
$44,256
When the project is terminated at the end of year 4, the equipment can be sold for $25,000. But,since it has been depreciated to a $0 book value, taxes must be paid on the full salvage value. For this project, the after-tax salvage cash flow is:
Salvage Value $25,000
Tax On Salvage Value (10,000)
Net After-Tax Salvage Cash Flow $15,000
Calculate the net cash flows for each of the 4 years. Based on these cash flows, what are the project’s NPV, IRR, MIRR, PI, payback, and discounted payback? Do these indicators suggest the project should be undertaken? Explain.
Answer: The net cash flows are:
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
Answer: Risk throughout finance relates to uncertainty about future events, and in capital budgeting, this means the future profitability of a project. For certain types of projects, it is possible to look back at historical data and to statistically analyze the riskiness of the investment. This is often true when the investment involves an expansion decision; for example, if Sears were opening a new store, if Citibank were opening a new branch, or if GM were expanding its Chevrolet plant, then past experience could be a useful guide to future risk. Similarly, a company that is considering going into a new business might be able to look at historical data on existing firms in that industry to get an idea about the riskiness of its proposed investment. However, there are times when it is impossible to obtain historical data regarding proposed investments; for example, if GM were considering the development of an electric auto, not much relevant historical data for assessing the riskiness of the project would be available. Rather, GM would have to rely primarily on the judgment of its executives, and they, in turn would have to rely on their experience in developing, manufacturing, and marketing new products. We will try to quantify risk analysis, but you must recognize at the outset that some of the data used in the analysis will necessarily be based on subjective judgments rather than on hard statistical observations.
Year 1 Year 2 Year 3 Year 4 Units 1350 1350 1350 1350 Unit Price $200.00 $206.00 $212.18 $218.55 Unit Cost $100.00 $103.00 $106.09 $109.27 Sales $270,000 $278,100 $286,443 $295,043 Costs $135,000 $139,050 $143,222 $147,515Related Questions
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