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 the main plant. The machinery$$s invoice price would be approximately $$200,000,$ another $$10,000$ in shipping charges would be required, and it would cost an additional $$30,000$ 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 $$25,000$ after $4$ years of use.

The new line would generate incremental sales of $1,000$ 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. The sales price and cost are both expected to increase by $3\%$ per year due to inflation. Further, to handle the new line, the firm$$s net working capital would have to increase by an amount equal to $12\%$ of sales revenues. The firm$$s tax rate is $25\%,$ and its overall weighted average cost of capital, which is the risk$-$adjusted cost of capital for an average project $($r$),$ is $10\%.$

Define $$incremental cash flow.$$

$(1)$Should you subtract interest expense or dividends when calculating project cash flow?

$(2)$Suppose the firm spent $$100,000$ last year to rehabilitate the production line site. Should this be included in the analysis? Explain.

$(3)$Now assume 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?

Disregard the assumptions in part a$.$ What is the depreciable basis? What are the annual depreciation expenses?

Calculate the annual sales revenues and costs $($other than depreciation$).$ Why is it important to include inflation when estimating cash flows?

Calculate annual net operating profit after sales $($NOPAT$).$ Then calculate the project recurring cash flows.

Estimate the required net operating working capital $($NOWC$)$ for each year and the cash flow due to changes in NOWC.

Calculate the after$-$tax salvage cash flow.

Calculate the project$$s cash flows for each year. Based on these cash flows and the average project cost of capital, what are the project$$s NPV$,$ IRR, MIRR, PI$,$ payback, and discounted payback? Do these indicators suggest that the project should be undertaken?

What does the term $$risk$$ mean in the context of capital budgeting; to what extent can risk be quantified; and, when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates?

$(1)$What are the three types of risk that are relevant in capital budgeting?

$(2)$How is each of these risk types measured, and how do they relate to one another?

$(3)$How is each type of risk used in the capital budgeting process?

$(1)$What is sensitivity analysis?

$(2)$Perform a sensitivity analysis on the cost per unit, unit sales, and salvage value. Assume each of these variables can vary from its base$-$case, or expected, value by plus or minus $10\%,20\%,$ and $30\%.$ Include a sensitivity graph, and discuss the results.

$(3)$What is the primary weakness of sensitivity analysis? What is its primary usefulness?

Assume that Sidney Johnson is confident of her estimates of all the variables that affect the project$$s cash flows except unit sales and sales price: If product acceptance is poor, unit sales would be only $800$ units a year and the unit price would only be $$160$; a strong consumer response would produce sales of $1,200$ 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$$s expected NPV$,$ as well as the NPV$$s standard deviation and coefficient of variation.

Are there problems with scenario analysis? Define simulation analysis and discuss its principal advantages and disadvantages.

$(1)$Assume the company$$s average project has a coefficient of variation in the range of $0\mathrm{.}2$ to $0\mathrm{.}4.$ 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?

$(3)$Are there any subjective risk factors that should be considered before the final decision is made?

What is a real option? What are some types of real options?