Chapter 11, Problem 1MC

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 1,000 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 25%, and its overall weighted average cost of capital, which is the risk-adjusted cost of capital for an average project (r), is 10%.

Define “incremental cash flow.”

1. (1) Should you subtract interest expense or dividends when calculating project cash flow?
2. (2) Suppose the firm spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain.
3. (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. (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?