Reference no: EM132995222

Question - Fred Smith, the CFO of Smith Forging Products has requested your assistance in evaluating a capital budgeting proposal. The proposal involves the production of a new line of gearboxes for use in heavy freight applications. Research and development costs to develop this new line of gearboxes of $300,000 were incurred last year. Production of the new product would require investment in new machinery. The machinery to be purchased would cost $4,100,000, and would have a useful life of 5 years. Smith Forging Products has conferred with its tax accountant and has been informed that they must depreciate the machinery under the MACRs 5-year class. The machinery is expected to have a market value of only $189,000 at the end of the 5-year period.

Management expects to sell 5,450 gearboxes in years 1 and 2, and 6,200 gearboxes in each of the remaining three years. The sales price per gearbox is projected to be $815 in year one, and management believes that the sales price will increase by 3% per year over the life of the project. Variable production costs are projected to be $590 per gearbox in year one and management expects these costs to increase by 2.5% per year over the life of the project. Fixed production costs are expected to be $65,000 in the first year and are expected to increase at a rate of 2% per year.

If the new line of gearboxes is produced, Smith Forging Products will need to make additional investments in Net Working Capital (NWC) to support the increased operations. In particular, the increase in NWC (at time t) is expected to be 10% of incremental sales between time t and time t+1. Thus, the NWC investments at t=0 would be 10% of the projected sales for t=1. Additional NWC investments would be required to support any further increases in sales and the cumulative investments in NWC made as a result of this project would be recovered at the project's end.

The discount rate (WACC - Weighted Average Cost of Capital) used to evaluate this project would be 10.12%, and the relevant tax rate is 36%.

Develop the incremental cash flow projections for this proposal. Clearly identify:

(1) incremental operating cash flows (OCF),

(2) NWC cash flows,

(3) net capital spending, and then,

(4) sum these three figures to get free cash flow (FCF).

Next, use the projected free cash flows to calculate the project's NPV, IRR, MIRR, PI, payback, and discounted payback.