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