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Iron Ore What? (IOW) Casting Company is considering adding a new line to its product mix. Sydney Johnson, a recently minted MBA, will be conducting the capital budgeting analysis. The new production line would be set up in unused space in IOW's main plant. The machinery invoice price totals approximately $250,000, with another $20,000 in shipping charges and $30,000 to install the equipment, for a total requirement estimated at $300,000. The machinery has an economic life of 4 years, and IOW has obtained a special tax ruling that places the equipment in the Modified Accelerated Cost Recovery System (MACRS) 3-year class. After 4 years of use the machinery is expected to have a salvage value of $25,000.
The new product line would generate incremental sales of 1,350 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 each 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 working capital would have to increase by an amount equal to 15% of sales revenues. The firm's tax rate is 40%, and its overall weighted average cost of capital is 12%.
Assume that Sydney Johnson is confident of her estimates of all the variables that affect the project's cash flowsexceptunit sales and sales price. If product acceptance is poor, unit sales could be only approximately 1,000 units a year and the unit price would be set at $150. Conversely, an excellent consumer response could produce sales of 2,000 units and a unit price of $220. 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). 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 project's expected NPV, standard deviation, and coefficient of variation.
Assume that IOW's average project has a coefficient of variation in the range of 0.2 to 0.4. Would the new product line be classified as high risk, average risk, or low risk? What type of risk is being measured here?
IOW typically adds or subtracts 5 percentage points to the overall cost of capital to adjust for risk. Given this consideration, should the new line be accepted? Explain.
Describe other subjective risk factors that should be considered before the final decision is made, and their individual impact on the project.

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Capital Cost

Machine cost $$$$,$$$

Shipping charges $$$,$$$

Installation $$$,$$$

Total Capital Cost $$$$,$$$

Salvage Value at end of 4 Yrs $$$,$$$

Year 1 2 3

Rate $$.$$% $$.$$% $$.$$%

Annual depreciation $$$,$$$ $$$$,$$$ $$$,$$$

Income Model

Units sold annually $,$$$

Revenue per unit - Yr 1 $$$$

Cost per unit - Yr 1 $$$$

Annual inflation $%

Net working capital (% of sales) $$%

WACC $$%

Net Working Capital

Year 0 1 2

Revenue $$$$,$$$ $$$$,$$$

Net Working Capital $$$,$$$ $$$,$$$ $$$,$$$

CF due to NWC or Incremental

NWC ($$$,$$$) ($$,$$$) ($$,$$$)

Year 4

Net Book Value $$

Salvage Value $$$,$$$

Capital Gain $$$,$$$

Tax on Capital Gain ($$$,$$$)

Post-tax salvage value $$$,$$$

Operating Model

Year 0 1 2

Revenue $$$$,$$$ $$$$,$$$

Less: Operating Cost ($$$$,$$$) ($$$$,$$$)

EBITDA $$$$,$$$ $$$$,$$$

Less: Depreciation ($$$,$$$) ($$$$,$$$)

Operating Profit $$$,$$$ $$,$$$

Less: Tax ($$$,$$$) ($$,$$$)

Operating Profit after tax $$$,$$$ $$,$$$

Add: Depreciation $$$,$$$ $$$$,$$$

Cash flow from operations $$$$,$$$ $$$$,$$$

Less: Initial investment ($$$$,$$$)

Less: Incremental NWC ($$$,$$$) ($$,$$$) ($$,$$$)

Add: After-tax salvage value

Add: Recovery of NWC

Project's Net Free Cash Flow ($$$$,$$$) $$$$,$$$ $$$$,$$$

Discounted Free Cash Flow ($$$$,$$$) $$$$,$$$ $$$$,$$$

IRR $$.$% Since the NPV is positive and MIRR is more than WACC, the

project is profitable and hence should be considered.

Remarks

Since the NPV is positive and MIRR is more than WACC, the

project is profitable and hence should be considered.

MIRR $$.$%

Profitability Index (PI) $.$

Payback period (Years) $.$

Discounted Payback (Years) $.$

Sensitivity Analysis

1350 $$$,$$$ $$.$%

1485

1620

1755

1215

1080

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NPV MIRR

Of the three variables tested above, NPV and MIRR of the project is most sensitive to change in unit sales, moderately sen

Hence, cautionary measures should be taken if there is any stress observed in units sold and effective measures should be

steeper than the plots for other two variables and hence units sales is the most critical or sen

Scenario Analysis

Scenarios Probability NPV

Worst $$% ($$$$,$$$)

Base $$% $$$,$$$

Best $$% $$$$,$$$

Standard Deviation $$$$,$$$

Coefficient of Variation $.$$

Since the coefficient of variation at 2.19 is much above the range of average

project COV, the new project possess very high risk.

Given, risky nature of the project, the risk adjusted WACC would be

17%. Now the NPV at 17% WACC is $8,421 and MIRR is 17.7%. Since

NPV is positive and MIRR is still higher than WACC, the project should

be accepted.

Given, risky nature of the project, the risk adjusted WACC would be

17%. Now the NPV at 17% WACC is $8,421 and MIRR is 17.7%. Since

NPV is positive and MIRR is still higher than WACC, the project should

be accepted.

agement, Strategy,

PSIM, Online Test

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marks

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Salvage Value NPV MIRR WACC NPV MIRR

$25,000 $$$,$$$ $$.$% 12.0% $$$,$$$ $$.$%

$27,500 13.2%

$30,000 14.4%

$32,500 15.6%

$22,500 10.8%

$20,000 9.6%

$17,500 8.4%

NPV MIRR

NPV MIRR

o change in unit sales, moderately sensitive to change in WACC and is least affected by change in salvage value.

sold and effective measures should be initiated to restore the lost or declining sales. The plot of unit sales is much

e units sales is the most critical or sensitive variable in overall project consideration.

Capital Cost

Machine cost $$$$,$$$

Shipping charges $$$,$$$

Installation $$$,$$$

Total Capital Cost $$$$,$$$

Salvage Value at end of 4 Yrs $$$,$$$

Year 1 2 3

Rate $$.$$% $$.$$% $$.$$%

Annual depreciation $$$,$$$ $$$$,$$$ $$$,$$$

Income Model

Units sold annually $,$$$

Revenue per unit - Yr 1 $$$$

Cost per unit - Yr 1 $$$$

Annual inflation $%

Net working capital (% of sales) $$%

WACC $$%

Year 0 1 2

Revenue $$$$,$$$ $$$$,$$$

Net Working Capital $$$,$$$ $$$,$$$ $$$,$$$

CF due to NWC or Incremental

NWC ($$$,$$$) ($$$$) ($$$$)

Year $

Net Book Value $$

Salvage Value $$$,$$$

Capital Gain $$$,$$$

Tax on Capital Gain ($$$,$$$)

Post-tax salvage value $$$,$$$

Operating Model

Year 0 1 2

Revenue $$$$,$$$ $$$$,$$$

Less: Operating Cost ($$$$,$$$) ($$$$,$$$)

EBITDA $$$,$$$ $$$,$$$

Less: Depreciation ($$$,$$$) ($$$$,$$$)

Operating Profit ($$$,$$$) ($$$,$$$)

Less: Tax $$$,$$$ $$$,$$$

Operating Profit after tax ($$$,$$$) ($$$,$$$)

Add: Depreciation $$$,$$$ $$$$,$$$

Cash flow from operations $$$,$$$ $$$,$$$

Less: Initial investment ($$$$,$$$)

Less: Incremental NWC ($$$,$$$) ($$$$) ($$$$)

Add: After-tax salvage value

Add: Recovery of NWC

Project's Net Free Cash Flow ($$$$,$$$) $$$,$$$ $$$,$$$

Discounted Free Cash Flow ($$$$,$$$) $$$,$$$ $$$,$$$

IRR -$.$%

MIRR $.$%

Profitability Index (PI) $.$

Payback period (Years) ($.$)

Discounted Payback (Years) $.$

Sensitivity Analysis

1000 ($$$$,$$$) $.$%

1100

1200

1300

900

800

700

NPV MIRR

4

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$25,000 ($$$$,$$$) $.$% 12.0% ($$$$,$$$) $.$%

$27,500 13.2%

$30,000 14.4%

$32,500 15.6%

$22,500 10.8%

$20,000 9.6%

$17,500 8.4%

NPV MIRR

N PV MIRR

Capital Cost

Machine cost $$$$,$$$

Shipping charges $$$,$$$

Installation $$$,$$$

Total Capital Cost $$$$,$$$

Salvage Value at end of 4 Yrs $$$,$$$

Year 1 2 3

Rate $$.$$% $$.$$% $$.$$%

Annual depreciation $$$,$$$ $$$$,$$$ $$$,$$$

Income Model

Units sold annually $,$$$

Revenue per unit - Yr 1 $$$$

Cost per unit - Yr 1 $$$$

Annual inflation $%

Net working capital (% of sales) $$%

WACC $$%

Year 0 1 2

Revenue $$$$,$$$ $$$$,$$$

Net Working Capital $$$,$$$ $$$,$$$ $$$,$$$

CF due to NWC or Incremental

NWC ($$$,$$$) ($$,$$$) ($$,$$$)

Year 4

Net Book Value $$

Salvage Value $$$,$$$

Capital Gain $$$,$$$

Tax on Capital Gain ($$$,$$$)

Post-tax salvage value $$$,$$$

Operating Model

Year 0 1 2

Revenue $$$$,$$$ $$$$,$$$

Less: Operating Cost ($$$$,$$$) ($$$$,$$$)

EBITDA $$$$,$$$ $$$$,$$$

Less: Depreciation ($$$,$$$) ($$$$,$$$)

Operating Profit $$$$,$$$ $$$$,$$$

Less: Tax ($$$,$$$) ($$$,$$$)

Operating Profit after tax $$$,$$$ $$$,$$$

Add: Depreciation $$$,$$$ $$$$,$$$

Cash flow from operations $$$$,$$$ $$$$,$$$

Less: Initial investment ($$$$,$$$)

Less: Incremental NWC ($$$,$$$) ($$,$$$) ($$,$$$)

Add: After-tax salvage value

Add: Recovery of NWC

Project's Net Free Cash Flow ($$$$,$$$) $$$$,$$$ $$$$,$$$

Discounted Free Cash Flow ($$$$,$$$) $$$$,$$$ $$$$,$$$

IRR $$.$%

MIRR $$.$%

Profitability Index (PI) $.$

Payback period (Years) $.$

Discounted Payback (Years) $.$

Sensitivity Analysis

2000 $$$$,$$$ $$.$%

2200

2400

2600

1800

1600

1400

NPV MIRR

4

$.$$%

$$$,$$$

3 4

$$$$,$$$ $$$$,$$$

$$$,$$$ $

($$,$$$) $$$,$$$

3 4

$$$$,$$$ $$$$,$$$

($$$$,$$$) ($$$$,$$$)

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($$$,$$$) ($$$,$$$)

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$$$$,$$$ $$$$,$$$

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$$$$,$$$ $$$$,$$$

$$$$,$$$ $$$$,$$$

$25,000 $$$$,$$$ $$.$% 12.0% $$$$,$$$ $$.$%

$27,500 13.2%

$30,000 14.4%

$32,500 15.6%

$22,500 10.8%

$20,000 9.6%

$17,500 8.4%

NPV MIRR

N PV MIR R

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