Shrieves Casting Company is considering adding a new line to its product mix, an

Question

Shrieves Casting Company is considering adding a new line to its product mix, and the capital bud¬ geting analysis is being conducted by Sidney John¬ son, 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 ap¬ proximately $200,000, another $10,000 in shipping charges would be required, and it would cost an addi¬ tional $30,000 to install the equipment. The machin¬ ery has an economic life of 4 years, and Shrieves has obtained a special tax ruling that places the equip¬ ment 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 deprecia¬ tion. 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 is 10%. A. Define “incremental cash flow”- the difference between the cash flows the firm will have if it implements the project versus the cash flows it will have if it rejects the project. (1) Should you subtract interest expense or dividends when calculating project cash flow? Yes (2) Suppose the firm spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain. Yes, because the amount is part of the capital expenditure. (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? Yes, because it should be subtracted out of the annual revenue. (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 con¬sidered in the analysis? If so, how? Yes, it should also be subtracted out of the annual revenue. b. Disregard the assumptions in part a. What is Shrieves’ depreciable basis? What are the annual depreciation expenses? 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. e. Estimate the required net working capital for each year and the cash flow due to investments in net working capital. f. Calculate the after¬tax salvage cash flow. g. Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR, MIRR, PI, payback, and discounted pay¬ back? Do these indicators suggest that the proj¬ ect should be undertaken?

Explanation / Answer

Since, there are multiple parts to the question part a has multiple subparts, I have answered all the subparts of Part A) as some of the answers provided along with the question are not correct, Part B, Part C and Part D with all the details.

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Part A)

Define “incremental cash flow”

The incremental cash flows indicate the cash flows the firm would derive if it implements the project minus the cash flows it will get if the project is rejected.

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Part A-1)

Should you subtract interest expense or dividends when calculating project cash flow?

No, the interest expense or dividends should not be deducted when calculating project cash flow. It is because, if such costs are deducted we would be reducing the cash flows by twice the amount of such (capital) costs as the cash flows (once calculated) would finally be discounted with the use of cost of capital (or rate of return required by all investors which includes both shareholders and debtholders). So, we should only discount the cash flows with the cost of capital (as both dividends and interest expense are a part of it.

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Part A-2)

Suppose the firm spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis?

No, the amount spent last year to rehabilitate the production line site should not be included in the analysis. It is because this cost has already been incurred and will be treated as a sunk cost.

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Part A-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?

Yes, the amount of $25,000 per year should be included in the analysis as it is the opportunity cost associated with pursuing the project. In other words, if the project is accepted and plant space is utilized, Shrieves won't be able to earn $25,000 (pre-tax) per year. The actual loss of earnings would, however, be post-tax for an amount of $15,000 [25,000*(1-40%)].

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Part A-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 con¬sidered in the analysis?

Yes, the decrease in sales of the firm’s other lines by $50,000 per year should be considered in the analysis. It is because this reduction in sales of (other lines) would result in a cash flow reduction of some amount. This net reduction would be treated as cost of accepting the new project. The effect of new project on the cash flows of other projects is considered as an externality which can have a positive or negative effect depending on the nature of the new project proposed to be undertaken.

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Part B)

What is Shrieves’ depreciable basis? What are the annual depreciation expenses?

The depreciable basis is calculated as below:

Depreciable Basis = Cost of Machine + Shipping Charges + Installation Costs = 200,000 + 10,000 + 30,000 = $240,000

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The annual depreciation expense is arrived as follows:

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Part C)

Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows?

The annual sales revenues and costs (other than depreciation are calculated as below:

It is important to include inflation when estimating cash flows because the discount rate (or the nominal cost of capital) at which such net cash flows will finally get discounted includes some percentage of inflation premium. In other words, in order to determine the true value of the project, it is essential to discount the cash flows (as adjusted for inflation) with the nominal cost of capital.

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Part D)

The value of annual incremental operating cash flow statements is determined as below:

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Notes:

1) There can be a slight difference in numerical values on account of rounding off values.

Year Depreciable Basis [A] Depreciation Rate (MACRS) [B] Annual Depreciation Expense [A*B] 1 240,000 33% $79,200 2 240,000 45% $108,000 3 240,000 15% $36,000 4 240,000 7% $16,800

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