Question

**Capital Budgeting**

Gilroy’s Casting Company, which has historically specialized in aluminum casting is considering adding a new bronze casting line to its production facility. Over the past several years the artistic community in Park City and along the Wasatch front has significantly increased and the company has received an increasing number of requests to do bronze castings.

The casting line would be set up in unused space in Gilroy’s main plant. The equipment would cost approximately $200,000, plus another $10,000 for shipping and an additional $30,000 for installation. The equipment has an economic life of 5 years, and would be depreciated to zero using straight line depreciation. But Mr. Gilroy believes the equipment will last much longer than 5 years. He expects it to last eight years, so this is an eight year project. The machinery is expected to have a salvage value of $25,000.

It is expected that the new line would generate new product sales of 500 units in the first year and will increase by 250 units per year until a volume of 1,250 units is reached. The variable cost of production is $100 per unit in the first year. Each unit can be sold for $200. 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 12% of revenue and this investment needs to be in place at the beginning of each year. The firm’s tax rate is 40%, and its overall weighted average cost of capital is 12%.

a. Define “incremental cash flow.”

1. Should you subtract interest expense or dividends when calculating project cash flow? Why or why not?

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.

3. Now assume that 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?

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?

b. Disregard the assumptions in part a. What is Gilroy’s 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, and payback? Do these indicators suggest the project should be undertaken?

h. 1. What is sensitivity analysis?

2. Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the project. Assume each of these variables can vary from its base-case, or expected, value by ±10% and ±20%. Include a table presenting the results and discuss what the results mean.

3. What is the primary weakness of sensitivity analysis? What is its primary usefulness?

i. Assume that Sidney Johnson is confident of her estimates of all the variables that affect the project’s cash flows except unit sales and sales price. If product acceptance is poor, unit sales would be only 75% of the forecast and the unit price would only be $160; a strong consumer response would produce sales of 125% of the forecast units and a unit price of $240. Sidney believes that there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case).

1. What is scenario analysis?

2. What is the worst-case NPV? The best-case NPV?

3. Use the worst-, base-, and best-case NPVs and probabilities of occurrence to find the project’s expected NPV.

j. Are there problems with scenario analysis? Discuss its principal advantages and disadvantages.

Submit a professionally prepared type written report answering all of the questions. Include any appropriate table, schedules or files showing your work and how you calculated your figures.

When answering the questions assume you are explaining your work to someone who is not experienced in finance.

It is recommended (but not required) that you do your spreadsheets in Excel.

Let me know if you have any questions.

Answer #1

Capital Budgeting
Gilroy’s Casting Company, which has historically specialized in
aluminum casting is considering adding a new bronze casting line to
its production facility. Over the past several years the artistic
community in Park City and along the Wasatch front has
significantly increased and the company has received an increasing
number of requests to do bronze castings.
The casting line would be set up in unused space in Gilroy’s
main plant. The equipment would cost approximately $200,000, plus
another...

Gilroy’s Casting Company, which has historically specialized in
aluminum casting is considering adding a new bronze casting line to
its production facility. Over the past several years the artistic
community in Park City and along the Wasatch front has
significantly increased and the company has received an increasing
number of requests to do bronze castings.
The casting line would be set up in unused space in Gilroy’s
main plant. The equipment would cost approximately $200,000, plus
another $10,000 for shipping...

CASE-PART A
Shrieves Casting Company is considering adding a new
product line to its product mix, and the capital budgeting analysis
is being conducted by Sidney Johnson, a recent business school
graduate. The production line would be set up in unused space in
Shrieves’s main plant. The machinery’s invoice price would be
approximately $200,000, another $10,000 in shipping charges would
be required to acquire the machinery from the supplier, and it
would cost an additional $30,000 to install the equipment....

Sugar Land Company is considering adding a new line to its
product mix, and the capital budgeting analysis is being conducted
by a MBA student. The production line would be set up in unused
space (Market Value Zero) in Sugar Land’ main plant. Total cost of
the machine is $330,000. The machinery has an economic life of 4
years and will be depreciated using MACRS for 3-year property
class. The machine will have a salvage value of $35,000 after 4...

Company is considering adding a new line to its product mix, and
the capital budgeting analysis is being conducted by a MBA student.
The production line would be set up in unused space (Market Value
Zero) in Sugar Land’ main plant. Total cost of the machine is
$350,000. The machinery has an economic life of 4 years and will be
depreciated using MACRS for 3-year property class. The machine will
have a salvage value of $35,000 after 4 years.
The...

Nippon Inc is considering a project that has an up-front cost of
$500,000. The project’s subsequent cash flows depend on whether its
products become the industry standard. There is a 60% chance that
products will become the industry standard, in which case the
project’s expected cash flows will be $120,000 per year for the
next 7 years. There is a 40% chance that products will not become
the industry standard, in which case the project’s expected cash
flows will be...

Suppose Cute Camel Woodcraft Company is evaluating a proposed
capital budgeting project (project Alpha) that will require an
initial investment of $450,000. The project is expected to generate
the following net cash flows:
Year
Cash Flow
Year 1
$375,000
Year 2
$475,000
Year 3
$400,000
Year 4
$500,000
Cute Camel Woodcraft Company’s weighted average cost of capital
is 10%, and project Alpha has the same risk as the firm’s average
project. Based on the cash flows, what is project Alpha’s...

Suppose Happy Dog Soap Company is evaluating a proposed capital
budgeting project (project Alpha) that will require an initial
investment of $600,000. The project is expected to generate the
following net cash flows:
Year Cash Flow
Year 1 $275,000
Year 2 $450,000
Year 3 $450,000
Year 4 $475,000
1. Happy Dog Soap Company’s weighted average cost of capital is
8%, and project Alpha has the same risk as the firm’s average
project. Based on the cash flows, what is project...

Blue Llama Mining Company is evaluating a proposed capital
budgeting project (project Delta) that will require an initial
investment of $1,500,000.
Blue Llama Mining Company has been basing capital budgeting
decisions on a project’s NPV; however, its new CFO wants to start
using the IRR method for capital budgeting decisions. The CFO says
that the IRR is a better method because percentages and returns are
easier to understand and to compare to required returns. Blue Llama
Mining Company’s WACC is...

When projects involve certain, or constant, cash flows, the
capital budgeting analysis that can be conducted is very simple and
straightforward. Unfortunately, this type of project rarely
exists.
When a project’s cash flows, or the conditions that affect their
magnitude or timing, vary from their expected values, then the
analysis becomes more complicated. Projects that have the potential
to exhibit greater or lesser levels of risk than the firm’s
average, or normal, level means that adjustments should be made to...

ADVERTISEMENT

Get Answers For Free

Most questions answered within 1 hours.

ADVERTISEMENT

asked 22 minutes ago

asked 36 minutes ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 2 hours ago

asked 2 hours ago

asked 2 hours ago

asked 2 hours ago

asked 2 hours ago

asked 2 hours ago