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%. 9. 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? 10. 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. 11. Describe other subjective risk factors that should be considered before the final decision is made, and their individual impact on the project.

Explanation / Answer

9. The coefficient of variance is in the range of 0.2 to 0.4 which is lower than 1. When the coefficient of variance is lower than 1, it indicates lower variance and hence lower risk. If the coefficient of variance is higher than 1, then it indicates higher risk . Since the coefficient of variance is lower than 1 and is in the range of 0.2 to 0.4, the product line would be classified as low risk.

Here the average risk of a project that IOW undertakes is being measured. Basically, it is measuring the probability of success or failure of a project undertaken by IOW. Hence with the risk being low, we can say that IOW is fairly successful in all its projects.

10. With a 5% risk factor, the cost of capital can be 12*0.95 which is 11.4% or 12*1.05 = 12.6%

Since the cost of capital varies in between a small range, we can say that the business can take the risk and accept the project.

Additionally, to further evaluate the, project, we need to calculate the IRR of the project and then compare it with the risk adjusted cost of capital. Since the IRR is not given, we go with the above calculation

11. The other subjective risk factors to be considered are:

a. The situation of the overall economy - whether it is strong, normal or a recessionary economy

b. The success rate of the competitors in this business with a similar risk project

c. Geo-political risk wherein in the local politics may affect the business adversely.

d. The possibility of interest rate hikes or reductions in the future which will affect the cost of debt and ultimately the cost of capital of this project.

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