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[answered] Mini Case 2 Situation Shrieves Casting Company is consideri


I need help on the data tables and the scenario manager sections. Thanks


Mini Case 2

 

Situation 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 $250,000, another $25,000 in

 

shipping charges would be required, and it would cost an additional $20,000 to install the equipment. The

 

machinery has an economic life of 4 years, and Shrieves has obtained a special tax ruling that places the equipment

 

in the MACRS 3-year class. The machinery is expected to have a salvage value of $35,000 after 4 years of use. The new line would generate incremental sales of 1,500 units per year for 4 years at an incremental cost of $140 per

 

unit in the first year, excluding depreciation. Each unit can be sold for $250 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 next year's sales revenues. The firm?s tax rate

 

is 40%, and its overall weighted average cost of capital is 10%.

 

a. Define ?incremental cash flow.?

 

Incremental cash flow is the firm's project's cash flow minus the firm's cash flow without the project. (1.) Should you subtract interest expense or dividends when calculating project cash flow?

 

No, we discount the project's cash flows with a cost of capital that is the rate of return that is required by all

 

investors, so we should discount the total amount of cash flows available to all investors. They are part of the

 

cost of capital. If we were to subtract them from cash flows we would be double counting capital costs. (2.) Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this be

 

included in the analysis? Explain.

 

That cost the firm would spend be spent last year and wouldmost likely be used for tax purpose. It should not be

 

included in the analysis because it is a sunk cost. (3.) Now assume that the plant space could be leased out to another firm at $25,000 per year. Should this be

 

considered in the analysis? If so, how?

 

included in the analysis? If so, how?

 

If the plant space isn't leased out then the firm would lose $25,000 in annual cash flows. This represents an

 

opportunity cost for the project and hence be included in the analysis. If the plant space isn't leased out then the firm would lose $25,000 in annual cash flows. This represents an

 

opportunity cost for the project and hence be included in the analysis. (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? This would be considered an extranality which should be considered in the analysis. If the firm's sales are

 

reduced by 50,000 then the loss would be a cost to the project. Analysis of New Expansion Project

 

Part I: Input Data

 

Equipment cost

 

Shipping charge

 

Installation charge

 

Economic Life

 

Salvage Value

 

Tax Rate

 

Cost of Capital

 

Units Sold

 

Sales Price Per Unit

 

Incremental Cost Per Unit

 

NOWC/Sales

 

Inflation rate $250,000

 

$25,000

 

$20,000

 

4

 

$35,000

 

40%

 

10%

 

1,500

 

$250

 

$140

 

12%

 

3% Key Output: NPV = $129,751 b. What is Shrieves' depreciable basis? What are the annual

 

depreciation expenses?

 

Annual Depreciation Expense

 

Depreciable Basis = Equipment + Freight + Installation

 

Depreciable Basis =

 

$295,000 Year

 

1

 

2

 

3

 

4 %

 

0.3333

 

0.4445

 

0.1481

 

0.0741 x

 

X

 

X

 

X

 

X Basis

 

$295,000

 

295,000

 

295,000

 

295,000 =

 

=

 

=

 

=

 

= Depr.

 

$98,324

 

$131,128

 

$43,690

 

$21,860 Remaining

 

Book Value

 

$196,677

 

65,549

 

21,860

 

0 c. Why is it important to include inflation when estimating cash flows?

 

It is important to include inflation when estimating cash flows because the cost of capital includes a premium for

 

inflation because it is a nominal cost. It is larger than the real cost of capital. It is important to include inflation when estimating cash flows because the cost of capital includes a premium for

 

inflation because it is a nominal cost. It is larger than the real cost of capital. d. Construct annual incremental operating cash flow statements.

 

Annual Operating Cash Flows

 

Units

 

Unit price

 

Unit cost Year 1

 

1,500

 

$250.00

 

$140.00 Year 2

 

1,500

 

$257.50

 

$144.20 Year 3

 

1,500

 

$265.23

 

$148.53 Year 4

 

1,500

 

$273.18

 

$152.98 Sales

 

Costs

 

Depreciation

 

Operating income before taxes (EBIT)

 

Taxes (40%)

 

EBIT (1 ? T)

 

Depreciation

 

Net operating CF $375,000

 

210,000

 

98,324

 

$66,677

 

26,671

 

$40,006

 

98,324

 

$138,329 $386,250

 

216,300

 

131,128

 

$38,823

 

15,529

 

$23,294

 

131,128

 

$154,421 $397,838

 

222,789

 

43,690

 

$131,359

 

52,544

 

$78,815

 

43,690

 

$122,505 $409,773

 

229,473

 

21,860

 

$158,440

 

63,376

 

$95,064

 

21,860

 

$116,924 e. Estimate the required net working capital for each year, and the cash flow due to investments in net working

 

capital.

 

Annual Cash Flows due to Investments in Net Working Capital

 

Year 0

 

Sales

 

NOWC (% of sales)

 

CF due to investment in NOWC 45,000

 

(45,000) Year 1

 

$375,000

 

46,350

 

(1,350) Year 2

 

$386,250

 

47,741

 

(1,391) Year 3

 

$397,838

 

49,173

 

(1,432) Year 4

 

$409,773

 

49,173 f. Calculate the after-tax salvage cash flow.

 

Hypothetical: If sold after

 

3 years for After-tax Salvage Value

 

Based on

 

facts in case:

 

$35,000

 

0

 

$35,000

 

14,000

 

$21,000 Salvage value

 

Book value

 

Gain or loss

 

Tax on salvage value

 

Net terminal cash flow $25,000

 

$25,000

 

21,860

 

$3,141

 

1,256

 

$23,744 $10,000

 

$10,000

 

21,860

 

($11,860)

 

(4,744)

 

$14,744 g. Calculate the net cash flows for each year. Based on these cash flows, what are the project?s NPV, IRR,

 

MIRR, and payback? Do these indicators suggest the project should be undertaken? Projected Net Cash Flows

 

Year 0

 

Investment Outlay: Long Term Assets

 

Operating Cash Flows

 

CF due to investment in NWC

 

Salvage Cash Flows

 

Net Cash Flows

 

NPV

 

IRR $129,751

 

26.0% Year 1 Year 2 Year 3 Year 4 $122,505 $116,924

 

(1,432)

 

49,173

 

21,000

 

$121,073 $187,096 ($295,000)

 

(45,000) $138,329

 

(1,350) $154,421

 

(1,391) ($340,000) $136,979 $153,031 PV of InflowsTV of Inflows

 

$469,751

 

$687,763

 

Years Find MIRR 0

 

($340,000) Net Cash Flows PV= 1

 

$136,979 2

 

$153,031 3

 

$121,073 ($340,000) 4

 

$187,096

 

133,180

 

185,167

 

182,320

 

$687,763 To find MIRR, we could now find the discount rate that equates the PV and TV. But it is easier to use the MIRR

 

function.

 

MIRR =

 

19.3% Find Payback

 

Cash Flow

 

Cumulative Cash Flow for Payback

 

If Function

 

Payback = 2.41 0

 

($340,000)

 

($340,000) 1

 

$136,979

 

($203,021)

 

$0

 

Precentrank funciton

 

$2.41 Years

 

2

 

$153,031

 

($49,990)

 

$2.41 3

 

$121,073

 

$71,083

 

$0 4

 

$187,096

 

$258,179

 

$0 Risk in capital budgeting really means the probability that the actual outcome will be worse than the expected

 

outcome. For example, if there were a high probability that the expected NPV as calculated above will actually turn

 

out to be negative, then the project would be classified as relatively risky. The reason for a worse-than-expected

 

outcome is, typically, because sales were lower than expected, costs were higher than expected, and/or the project

 

turned out to have a higher than expected initial cost. In other words, if the assumed inputs turn out to be worse

 

than expected then the output will likewise be worse than expected. We use Excel to examine the project's sensitivity

 

to changes in the input variables.

 

h. (1.) What are the three types of risk that are relevant in capital budgeting? The three types of risk are stand-alone risk, within-firm risk, and market risk. (2.) How is each of these risk types measured, and how do they relate to one another? Stand alone risk is measured by the project's standard deviation of NPV or can also be measured by it's

 

coefficient of variation of NPV. Within-firm risk is measured by the project's beta, which is the slope of the

 

regression line formed by plotting the returns on the prjoect versus the returns of the firm overall. Market risk is

 

measured by the project's market beta, which is the slope of the regression line formed by plotting the overall

 

returns on the project versus the overall returns on the market. (3.) How is each type of risk used in the capital budgeting process? The most important is market risk because it pertains to shareholder's wealth. The total risk affects creditors,

 

customers, suppliers and employees. Stand-alone risk is usually highly dependant with its within-firm risk which

 

inturn is likely to be very dependent on its market risk. Evaluating Risk: Sensitivity Analysis

 

Sensitivity of NPV and to Variations in Input Variables

 

i. (1.) What is sensitivity analysis? Sensitivity Analysis measures the effect of changes in a particular variable on a project's net present value. Sensitivity Analysis measures the effect of changes in a particular variable on a project's net present value. (2.) Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the project. Assume that

 

each of these variables can vary from its base-case, or expected, value by plus and minus 10%, 20%, and 30%.

 

Include a sensitivity diagram, and discuss the results.

 

Here we use an Excel "Data Table" to find the NPVs for changes in unit sales, salvage value, and WACC holding

 

other things constant--changing one variable at a time. This produces the sensitivity analys as shown below.

 

We summarize the data tables and show the sensitivity analysis graph below:

 

% Deviation

 

from

 

Base Case

 

-30%

 

-15%

 

0%

 

15%

 

30% WACC

 

WACC

 

7.0%

 

8.5%

 

10.0%

 

11.5%

 

13.0% % Deviation 1st YEAR UNIT SALES % Deviation

 

SALVAGE

 

NPV

 

from

 

Units

 

NPV

 

from

 

Variable

 

NPV

 

129,751 Base Case

 

Sold

 

Base Case

 

Cost 129,751 Evaluating Risk: Sensitivity Analysis

 

NPV ($) Sensitivity Analysis 12 Units Sold 10

 

8 Salvage

 

Value 6

 

4 WACC 2

 

0

 

-40% -30% -20% -10% 0% 10% 20% 30% 40% Deviation from Base-Case Value

 

Deviation

 

from

 

Base Case

 

-30%

 

-15%

 

0%

 

15%

 

30% NPV Deviation from Base Case

 

Units

 

WACC

 

Sold

 

Salvage Range (3.) What is the primary weakness of sensitivity analysis? What is its primary usefulness? The primary weakness of sensitivity analysis is that it does not reflect the effects of diversification. A sensitivity

 

analysis might indicate that a project's NPV is very dependant on sales, this would actually not contribute much

 

to a project's risk. It's primary usefulness is that it identifies the variables that have the greatest impact on the

 

profit, which helps drive management's attention to things that are important. j. 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 1000 units a year and the

 

unit price would only be $200; a strong consumer response would produce sales of 1,800 units and a unit price of

 

$280. 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). j. 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 1000 units a year and the

 

unit price would only be $200; a strong consumer response would produce sales of 1,800 units and a unit price of

 

$280. 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? Scenario Analysis examines several possible situations that include worst case, most likely, and best case which in

 

turn provides a range of possible outcomes. (2.) What is the worst-case NPV? The best-case NPV? Work the table below.

 

(3.) Use the worst-, most likely, and best-case NPVs and probabilities of occurrence to find the project?s expected

 

NPV, standard deviation, and coefficient of variation. Work the table below. Evaluating Risk: Scenario Analysis

 

We could find the NPV by entering the value of unit sales and price for each scenario and then recording

 

the NPV (this is what we did for the table below). Alternatively, we could use Tools, Scenarios to define

 

the inputs for each scenario, which we did and show in the Scenario Summary Tab below. In fact, please

 

use scenario manage to create 3 cases and copy paste only value in the table below. This is a powerful

 

feature of Excel, and we encourage you to explore it. Scenario Analysis

 

Scenario

 

Best Case

 

Base Case

 

Worst Case Probability Unit Sales Unit Price 25%

 

50%

 

25% 1,800

 

1,500

 

1,000 $280

 

$250

 

$200 Expected NPV =

 

Standard Deviation =

 

Coefficient of Variation = Std Dev / Expected NPV = NPV

 

$297,093

 

$129,751

 

($71,447) Squared Deviation

 

times Probability

 

$7,726,937,409.00

 

$35,819,648.00

 

$9,286,598,689.00 $121,287

 

$130,573

 

1.08 Risk Adjusted Cost of Capital

 

k. (1.) Assume that Shrieves' average project has a coefficient of variation in the range of 0.2 to 0.4. Would the new

 

line be classified as high risk, average risk, or low risk? What type of risk is being measured here? (2.) Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk.

 

Should the new line be accepted? (2.) Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk.

 

Should the new line be accepted?

 

The CV of this project is 1.51, which is larger than the CV range of the firm's average project. Consequently, this

 

project is riskier than the firm's average project, so management should add 3% to the WACC to risk adjust.

 

Cost of capital for average projects:

 

Adjustment for risky projects:

 

Risk adjusted cost of capital:

 

NPV with risk-adjusted cost of:

 

capital

 

(3.) Are there any subjective risk factors that should be considered before the final decision is made? l. What is a real option? What are some types of real options? $250,000

 

$25,000

 

$20,000

 

4

 

$35,000

 

40%

 

10%

 

1,800

 

$280

 

$140

 

12%

 

3% NPV ($) Sensitivity Analysis 12 Units Sold 10

 

8 Salvage

 

Value 6

 

4 WACC 2

 

0

 

-40% -30% -20% -10% 0% 10% 20% 30% 40% Deviation from Base-Case Value $250,000

 

$25,000

 

$20,000

 

4

 

$35,000

 

40%

 

10%

 

1,500

 

$250

 

$140

 

12%

 

3% NPV ($) Sensitivity Analysis 12 Units Sold 10

 

8 Salvage

 

Value 6

 

4 WACC 2

 

0

 

-40% -30% -20% -10% 0% 10% 20% 30% 40% Deviation from Base-Case Value $250,000

 

$25,000

 

$20,000

 

4

 

$35,000

 

40%

 

10%

 

1,000

 

$200

 

$140

 

12%

 

3% NPV ($) Sensitivity Analysis 12 Units Sold 10

 

8 Salvage

 

Value 6

 

4 WACC 2

 

0

 

-40% -30% -20% -10% 0% 10% 20% 30% 40% Deviation from Base-Case Value

 


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