chapter13 - Chapter 13: MINI CASE Shrieves Casting Company...

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Chapter 13: MINI CASE 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: This is the firm’s cash flow with the project minus the firm’s cash flow without the project. a. 1. Should you subtract interest expense or dividends when calculating project cash flow? Answer: The cash flow statement should not include interest expense or dividends. The return required by the investors furnishing the capital is already accounted for when we apply the 10 percent cost of capital discount rate, hence including financing flows would be "double counting." Put another way, if we deducted capital costs in the table, and thus reduced the bottom line cash flows, and then discounted those CFS by the cost of capital, we would, in effect, be subtracting capital costs twice. a. 2. Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this cost be included in the analysis? Explain. Answer: The $100,000 cost to rehabilitate the production line site was incurred last year, and presumably also expensed for tax purposes. Since, it is a sunk cost , it should not be included in the analysis. Mini Case: 13 - 1
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a. 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: If the plant space could be leased out to another firm, then if Shrieves accepts this project, it would forgo the opportunity to receive $25,000 in annual cash flows. This represents an opportunity cost to the project, and it should be included in the analysis.
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chapter13 - Chapter 13: MINI CASE Shrieves Casting Company...

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