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 Shrieves’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. 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 firm’s net working capital would have to increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 40%, and its overall weighted average cost of capital is 10%.
1. Perform sensitivy 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 +- 10%, +-20%, and + - 30%. Include a sensitivity diagram and discuss results.
2. What is the primary weakness of sensitivity analysis? What is its primary usefulness?