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