Question

Shrek Casting Company is considering adding a new line to its product mix. The production line would be set up in unused space in Shrek's main plant. The machinery’s invoice price would be approximately $210,000; another $15,000 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 would be a class 8 with a 20% CCA rate. The machinery is expected to have a salvage value of $15,000 after 4 years of use.

The new line would generate incremental sales of 1,300 units per year for four years at an incremental cost of $125 per unit in the first year, excluding depreciation. Each unit can be sold for $225 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 operating working capital would have to increase by an amount of $35,000. The firm’s tax rate is 29%, and its overall weighted average cost of capital is 11 percent.

Answer 1

To determine whether adding a new line to its product mix is financially feasible, Shrek Casting Company needs to calculate the net present value (NPV) of the investment. NPV is the present value of the expected cash inflows minus the present value of the cash outflows. If the NPV is positive, it means the investment is financially viable and should be considered.

To determine whether adding a new line to its product mix is financially feasible, Shrek Casting Company needs to calculate the net present value (NPV) of the investment. NPV is the present value of the expected cash inflows minus the present value of the cash outflows. Here's how you can calculate the NPV:

Calculate the annual cash inflows by multiplying the incremental sales per year with the selling price per unit.

Calculate the annual cash outflows by subtracting the incremental cost per unit, excluding depreciation, from the selling price per unit and multiplying the result with the incremental sales per year.

Calculate the net cash flows by subtracting the annual cash outflows from the annual cash inflows.

Calculate the present value of the net cash flows for each year by discounting them using the weighted average cost of capital (WACC).

Calculate the sum of the present values of the net cash flows to get the total present value of the cash inflows.

Calculate the present value of the cash outflows by discounting the initial investment cost using the WACC.

Calculate the NPV by subtracting the present value of the cash outflows from the total present value of the cash inflows.

If the NPV is positive, it means the investment is financially viable and should be considered. If the NPV is negative, it means the investment is not financially viable and should not be pursued.