Types of risk that are relevant in capital budgeting

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Reference no: EM131818102

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) What are the three types of risk that are relevant in capital budgeting?

2) How is each of these risk types measured, and how do they relate to one another?

3) How is each type of risk used in the capital budgeting process

1) What is sensitivity analysis?

2) 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.

3) What is the primary weakness of sensitivty analysis? What is its primary usefulness?

Reference no: EM131818102

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