MINI CASE Shrieves Casting Company is considering adding a e

MINI CASE Shrieves Casting Company is considering adding a expected to have a salvage value of $25,000 after 4 new line to its product mix, and the capital bud geting analysis is being conducted by Sidney John son, a recently graduated MBA. The production line1,250 units per year for 4 years at an incremental cost would be set up in unused space in Shrieves\' main of S100 per unit in the first year, excluding deprecia- plant. The machinery\'s invoice price would be ap tion. Each unit can be sold for $200 in the first year proximately $200,000, another $10,000 in shipping The sales price and cost are both expected to increase charges would be required, and it would cost an addi- by 3% per year due to inflation. Further, to handle tional $30,000 to install the equipment. The machin- the new line, the firm\'s net working capital would ery has an economic life of 4 years, and Shrieves has have to increase by an amount equal to 12% of sales obtained a special tax ruling that places the equip- revenues. The firm\'s tax rate is 40%, and its overall ment in the MACRS 3-year class. The machinery is weighted average cost of capital is 10%. years of use The new line would generate incremental sales of

Solution

A. Incremental caah flow is a cash flow that a project generates over its period of life. It is the net cash flow which can be obtained as the cash flow with the project minus the cash flow without the project.

A. 1. The cash flow statement should not include intrest expense or dividends.

A.2 The firm had spent $100,000 last year to rehabilitate the production line site. This cost is a sunk cost and it should not be included in the analysis. Sunk cost cancannot be recovered and hence should not be considered when making the investment decision.

A.3 Assuming that he plant space could be leased out to another firm at $25000 a year. It represents an opportunity cost and it should be included in the analysis.

Opportunity cost = $25000 (1-t) =25000 (1-0.40) = $15000

A.4 Assuming that the new product line is expected to decrease sales of the firm\'s other lines by $50, 000 per year. This represent an externality which can be negative or positive and it should be included in the analysis.

B. Shrieves depreciable basis

C. Annual sales revene and costs

Inflation rate = 3%

The nominal cash flows are larger than real cash flows. There fore you should inflate cash flows and then discount at the nominal rate.

D. Annual incremental operating cash flows

12450

Year	Rate	Basis	Depreciation = rate*basis
1	0.33	$240	79
2	0.45	240	108
3	0.15	240	36
4	0.07	240	17
		Total	$240