Reference no: EM131585457

Merafe Mining is evaluating the possibility of adding a new product line to its product mix. Because the exercise requires a detailed analysis of all possible risk scenarios or cases, EY was contracted to perform capital budgeting analysis for Merafe. The new machinery would cost Merafe an estimated amount of R200 000. A further R10 000 would be required for shipping charges and additional amount of R30 000 is estimated for installation of the new equipment. Assume an economic life of 4 year for the machinery and the depreciation is based on MACRS 3-year class. Assume the following MACRS 3-year class depreciate rates: year 1: 33.33%, year 2: 44.45%, year 3: 14.81%, year 4: 7.41%. The machinery is expected to have a salvage value of R25 000 after 4 years of use. The new product line would generate incremental sales of 1 250 units per year for 4 years at an incremental cost of R100 per unit in the first year, excluding depreciation. Each unit can be sold for R200 in the first year. The sales price and cost are both expected to increase by 3% per year. Further, to handle the new line, the company’s net working capital would have to increase by an amount equal to 12% of sales revenues. Assume company’s tax rate of 40%, and its overall weighted average cost of capital, which is the risk-adjusted cost of capital for an average project (r), is 10%. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows.