Chapter 11 Mini Case

Situation 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 Shrieves' 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 which 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 four 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 expected to increase by 3% per year due to inflation. Further, to handle the new line, the firm’s net operating working capital would have to increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 40 percent, and its overall weighted average cost of capital is 10 percent. a. Define “incremental cash flow.” Answer: See Chapter 11 Mini Case Show (1.) Should you subtract interest expense or dividends when calculating project cash flow? Answer: See Chapter 11 Mini Case Show (2.) Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain. Answer: See Chapter 11 Mini Case Show (3.) Now assume that the plant space could be leased out to another firm at $25,000 a year. Should this be included in the analysis? If so, how? Answer: See Chapter 11 Mini Case Show (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? Answer:See Chapter 11 Mini Case Show Analysis of New Expansion Project Part I: Input Data Equipment cost $200,000

Shipping charge Installation charge Economic Life Salvage Value Tax Rate Cost of Capital Units Sold Sales Price Per Unit Incremental Cost Per Unit Inventory/sales Inflation rate

$10,000 $30,000 4 $25,000 40% 10% 1250 $200 $100 12% 3%

b. Disregard the assumptions in Part a. What is Shrieves' depreciable basis? What are the annual depreciation expenses? Annual Depreciation Expense Depreciable Basis = Equipment + freight + installation Depreciable Basis = $240,000 Year 1 2 3 4 % 0.33 0.45 0.15 0.07 x Basis $240,000 $240,000 $240,000 $240,000 = Depr. $79,200 $108,000 $36,000 $16,800

c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows? d. Construct annual incremental operating cash flow statements. Annual Operating Cash Flows Units Unit price Unit cost Sales Year 1 1250 $200.00 $100.00 $250,000 Year 2 1250 $206.00 $103.00 $257,500 Year 3 1250 $212.18 $106.09 $265,225 Year 4 1250 $218.55 $109.27 $273,188

Costs Depreciation Operating income before taxes (EBIT) Taxes (40%) Net operating profit after taxes Depreciation Net Operating CF

$125,000 $79,200 $45,800 $18,320 $27,480 $79,200 $106,680

$128,750 $108,000 $20,750 $8,300 $12,450 $108,000 $120,450

$132,613 $36,000 $96,612 $38,645 $57,967 $36,000 $93,967

$136,588 $16,800 $119,800 $47,920 $71,880 $16,800 $88,680

e. Estimate the required net operating working capital for each year, and the cash flow due to investments in net operating working capital. Annual Cash Flows due to Investments in Net Operating Working Capital Year 0 Sales NOWC (% of sales) CF due to investment in NOWC) f. Calculate the after-tax salvage cash flow. After-tax Salvage Value Salvage Value Tax on Salvage Value Net Terminal Cash Flow $25,000 $10,000 $15,000 $30,000 ($30,000) Year 1 $250,000 $30,900 ($900) Year 2...