# On the basis of information in the problem, would you recommend the project should be accepted?

Complete questions A through J for the Mini Case involving Shrieves Casting Company on pages 495 & 496. Please complete the paper in actual paper format including an introduction paragraph, a clearly labeled paragraph for each question (A, B, C, etc.), a conclusion paragraph, and a references page.

Start with the partial model in the file Ch11 P18 Build a Model.xlsx on the textbookâ€™s Web site. Webmasters.com has developed a powerful new server that would be used for corporationsâ€™ Internet activities. It would cost $10 million at Year 0 to buy the equipment necessary to manufacture the server. The project would require net working capital at the beginning of each year in an amount equal to 10% of the yearâ€™s projected sales; for example,

NWC0=10%(Sales1)

. The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 3%. The companyâ€™s nonvariable costs would be $1 million at Year 1 and would increase with inflation.

The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. Also, the projectâ€™s returns are expected to be highly correlated with returns on the firmâ€™s other assets. The firm believes it could sell 1,000 units per year.

The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of the equipment at the end of the projectâ€™s 4-year life is $500,000. Webmasters.comâ€™s federal-plus-state tax rate is 40%. Its cost of capital is 10% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 and 1.2. Low-risk projects are evaluated with an 8% project cost of capital and high-risk projects at 13%.

Develop a spreadsheet model, and use it to find the projectâ€™s NPV, IRR, and payback.

Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and number of units sold. Set these variablesâ€™ values at 10% and 20% above and below their base-case values. Include a graph in your analysis.

Now conduct a scenario analysis. Assume that there is a 25% probability that best-case conditions, with each of the variables discussed in Part b being 20% better than its base-case value, will occur. There is a 25% probability of worst-case conditions, with the variables 20% worse than base, and a 50% probability of base-case conditions.

If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and payback.

On the basis of information in the problem, would you recommend the project should be accepted?

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 machineryâ€™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 1,250 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. The sales price and cost are both expected to increase by 3% per year due to inflation. Further, to handle the new line, the firmâ€™s net working capital would have to increase by an amount equal to 12% of sales revenues. The firmâ€™s tax rate is 40%, and its overall weighted average cost of capital, which is the risk-adjusted cost of capital for an average project (r), is 10%.

Define â€œincremental cash flow.â€

Should you subtract interest expense or dividends when calculating project cash flow?

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

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?

Finally, assume that the new product line is expected to decrease sales of the firmâ€™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?

Construct annual incremental operating cash flow statements.

Estimate the required net working capital for each year and the cash flow due to investments in net working capital.

Calculate the after-tax salvage cash flow.

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

What does the term â€œriskâ€ 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?

What are the three types of risk that are relevant in capital budgeting?

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

How is each type of risk used in the capital budgeting process?

What is sensitivity analysis?

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 Â±10%, Â±20%, and Â±30%. Include a sensitivity diagram, and discuss the results.

What is the primary weakness of sensitivity analysis? What is its primary usefulness?

Assume that Sidney Johnson is confident in her estimates of all the variables that affect the projectâ€™s cash flows except unit sales and sales price. If product acceptance is poor, unit sales would be only 900 units a year and the unit price would only be $160; a strong consumer response would produce sales of 1,600 units and a unit price of $240. Johnson believes there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case).

What is scenario analysis?

What is the worst-case NPV? The best-case NPV?

Use the worst-, base-, and best-case NPVs and probabilities of occurrence to find the projectâ€™s expected NPV, as well as the NPVâ€™s standard deviation and coefficient of variation.

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

Assume the companyâ€™s 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?

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

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?

Include a title page and 3-5 references. Only one reference may be from the internet (not Wikipedia). The other references must be from the Grantham University online library. Please adhere to the Concise Guide to APA Style when writing and submitting assignments and papers.

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