I need some help with the second half of an assignment. I can\'t figure some of
ID: 461546 • Letter: I
Question
I need some help with the second half of an assignment. I can't figure some of this out! Any help is appreciated!!!
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%.
5.Assume that Sydney 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 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.
Explanation / Answer
We need to use Total Cost Of Ownership (TCO) to calculate Net Present Value (NPV) for the project.Once we calcualte NPV using TCO concept, we can calculate Expected Monetary Value under three sales scenarios using decision tree analysis..
Probably Coefficient of Variation data can be used to calcualte Projects values using NPV in decision tree analysis.
(Consider cash outflows as -ve values and all cash inflow such as sales, salvage value are +ve values while calcualating NPV using Excel sheet).At the end coose the project with higher NPV.
(Note: For TCO, please refer any SCM/Project Mgmt books, for NPV calculation, please refer finance books, for decison tree analysis use any Operations Research books)