John Crockett Furniture Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Joan Samuel, a recently graduated finance MBA. The production line would be set up in unused space in Crockett's 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. Further, the firm's inventories would have to be increased by $25,000 to handle the new line, but its accounts payable would rise by $5,000. The machinery has an economic life of 4 years, and Crockett 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 $125,000 in incremental net revenues (before taxes and excluding depreciation) in each of the next 4 years. The firm's tax rate is 40% and its overall weighted average cost of capital is 10%.
a)Construct the project's cash flows over its 4 year life. Based on these cash flows, what are the project's NPV and IRR? Do these indicators suggest that the project should be undertaken?
b)Assume now that the project is a replacement project rather than a new or expansion, project. Describe how the analysis would differ for a replacement project.
c)Explain what is meant by cash flow estimation bias. What are some steps that Crockett's management could take to eliminate the incentives for bias in the decision process?
d)In an unrelated analysis, Joan was asked to choose between the following two mutually exclusive projects:
Expected Net Cash Flow
year Project S Project L
0 -100,000 -100,000
1 60,000 33,500
2 60,000 33,500
3 - 33,500
4 - 33,500
The project provides a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future. Both projects have a 10% cost of capital.
(1)what is each project's initial NPV without replication? Can you use the information to determine which project should be chosen? Explain.
(2)Now apply the replacement chain approach to determine the project's extended NPVs. Which project should be chosen? Explain.
(3) Repeat the analysis using the equivalent annual annuity approach. Which project should be chosen? Explain.