Case Study: Project Valuation and Risk Analysis
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%.
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