Question

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. The machinery has an economic life of 4 years and would be in Class 8 with a CCA rate of 20%. 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 4 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. Furthermore, to handle the new line, the firm’s net operating working capital would be $80,000. The working capital would be sold for $80,000 at the end of its life. The firm’s tax rate is 30%, and its overall weighted average cost of capital is 10%.

CASE-PART B

The company would like to rerun the original information if sales only reaches 900 units per year.

REQUIRED:

DETERMINE WHETHER THE COMPANY GO AHEAD WITH THIS PROJECT OF ADDING A NEW PRODUCT LINE FOR PART A & B.

use excel for this problem and show all formulas. thanks

Answer 1

Answer - PART A

For determining whether the Shrieves Casting Company should go ahead with the project of adding a new product line we shall have to assess the Net Present Value (NPV) of the project for which following steps shall be followed:

Step - 1

Calculate the capital cost of the new machine that is to be depreciated using Class 8 CCA rate of 20%.

Statement showing total capital cost of the new machine

Particulars	Amount ($)
Machinery invoice price	200,000
Shipping charges	10,000
Installation charges	30,000
Total Capital Cost	240,000

Step - 2

Calculate the capital cost allowance of the new machine using Class 8 CCA rate of 20% that is required for calculating cash flows and tax benefit upon it.

Statement showing Capital Cost Allowance of the machine

Year	Particulars	Working	Amount ($)
0	Total Capital Cost		240,000
1	Capital Cost Allowance	(240,000 * 10%)	-24,000
1	Closing Balance at end		216,000
2	Capital Cost Allowance	(216,000 * 20%)	-43,200
2	Closing Balance at end		172,800
3	Capital Cost Allowance	(172,800 * 20%)	-34,560
3	Closing Balance at end		138,240
4	Capital Cost Allowance	(138,240 * 20%)	-27,648
4	Closing Balance at end		110,592

Step - 3

Calculate the annual cash flows using the sales unit given of 1,250 units, sales price given of $200 per unit for the first year and variable cost price given of $100 per unit for the first year. Assume that the sales price and variable cost price is constant in the rest three years in absence of the information available. Tax rate shall be considered as 30% of profits before tax.

Statement showing Cash Flows

Amount ($)

Particulars	Working	Year 1	Year 2	Year 3	Year 4
Sales	(1250 units @ $200 p.u.)	250,000	250,000	250,000	250,000
Variable Cost	(1250 units @ $100 p.u.)	-125,000	-125,000	-125,000	-125,000
Capital Cost Allowance		-24,000	-43,200	-34,560	-27,648
Profit before tax		101,000	81,800	90,440	97,352
Tax	30% of Profit before tax	-30,300	-24,540	-27,132	-29,206
Profit after tax		70,700	57,260	63,308	68,146
Capital Cost Allowance	Add back	24,000	43,200	34,560	27,648
Cash Flow		94,700	100,460	97,868	95,794

Step - 4

Calculate the Net Present Value of the project of adding a new product line using the Total capital cost of the machine calculated in Step-1 above, Closing Balance of the machine at the end of year 4 calculated in Step-2 above for calculating tax saving on capital loss on salvage value of machine, working capital requirement of $80,000 ,Cash flows calculated in Step-3 above and discount rate of 10% which is the overall weighted average cost of capital of Shrieves Casting Company.

Statement showing Net Present Value of the Project

Amount ($)

Year	Particulars	Notes / Working	Amount (A)	Discount Factor @ 10% (B)	Present Value     (A * B)
0	Capital cost of Machine	calculated in Step - 1	-240,000	1	-240,000
0	Working capital requirement	given in question	-80,000	1	-80,000
1	Cash Flows	calculated in Step - 3	94,700	0.9091	86,092
2	Cash Flows	calculated in Step - 3	100,460	0.8264	83,020
3	Cash Flows	calculated in Step - 3	97,868	0.7513	73,528
4	Cash Flows	calculated in Step - 3	95,794	0.6830	65,428
4	Salvage value of machine	given in question	25,000	0.6830	17,075
4	Tax saving on loss from sale of machine	($110,592 - $25,000) * 30%	25,678	0.6830	17,538
4	Working capital sold	given in question	80,000	0.6830	54,640
	Net Present Value	77,321

Note: Loss from sale of machine is calculated using the closing balance of the machine at the end of year 4 calculated in Step-2 above of $110,592 and the salvage value of the machine of $25,000 at the end of year 4 given in the question.

Since the NPV comes to positive $77,321 hence the proposal of adding a new product line to the product mix of Shrieves Casting Company is viable and shall be accepted.

Answer - PART B

If sales only reaches 900 units per year and other information remains the same then for determining whether the Shrieves Casting Company should go ahead with the project of adding a new product line we shall have to assess the Net Present Value (NPV) of the project.

Statement showing Cash Flows

Amount ($)

Particulars	Working	Year 1	Year 2	Year 3	Year 4
Sales	(900 units @ $200 p.u.)	180,000	180,000	180,000	180,000
Variable Cost	(900 units @ $100 p.u.)	-90,000	-90,000	-90,000	-90,000
Capital Cost Allowance		-24,000	-43,200	-34,560	-27,648
Profit before tax		66,000	46,800	55,440	62,352
Tax	30% of Profit before tax	-19,800	-14,040	-16,632	-18,706
Profit after tax		46,200	32,760	38,808	43,646
Capital Cost Allowance	Add back	24,000	43,200	34,560	27,648
Cash Flow		70,200	75,960	73,368	71,294

Statement showing Net Present Value of the Project

Amount ($)

Year	Particulars	Notes / Working	Amount (A)	Discount Factor @ 10% (B)	Present Value     (A * B)
0	Capital cost of Machine	calculated in Step - 1	-240,000	1	-240,000
0	Working capital requirement	given in question	-80,000	1	-80,000
1	Cash Flows	calculated in Step - 3	70,200	0.9091	63,819
2	Cash Flows	calculated in Step - 3	75,960	0.8264	62,773
3	Cash Flows	calculated in Step - 3	73,368	0.7513	55,121
4	Cash Flows	calculated in Step - 3	71,294	0.6830	48,694
4	Salvage value of machine	given in question	25,000	0.6830	17,075
4	Tax saving on loss from sale of machine	($110,592 - $25,000) * 30%	25,678	0.6830	17,538
4	Working capital sold	given in question	80,000	0.6830	54,640
	Net Present Value	-340

Note: Loss from sale of machine is calculated using the closing balance of the machine at the end of year 4 calculated in Step-2 above of $110,592 and the salvage value of the machine of $25,000 at the end of year 4 given in the question.

Since the NPV comes to negative $340 hence the proposal of adding a new product line to the product mix of Shrieves Casting Company is not financially viable and shall not be accepted since the company is not able to recover its overall weighted average cost of capital of 10%.