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**Chapter 11 Mini Case
**

Situation 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' 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 which 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 four 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 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 equal to 12% of sales revenues. The firm’s tax rate is 40 percent, and its overall weighted average cost of capital is 10 percent. a. Define “incremental cash flow.” Answer: See Chapter 11 Mini Case Show (1.) Should you subtract interest expense or dividends when calculating project cash flow? Answer: See Chapter 11 Mini Case Show (2.) Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain. Answer: See Chapter 11 Mini Case Show (3.) Now assume that the plant space could be leased out to another firm at $25,000 a year. Should this be included in the analysis? If so, how? Answer: See Chapter 11 Mini Case Show (4.) Finally, assume that the new product line is expected to decrease sales of the firm’s other lines by $50,000 per year. Should this be considered in the analysis? If so, how? Answer:See Chapter 11 Mini Case Show Analysis of New Expansion Project Part I: Input Data Equipment cost Shipping charge Installation charge Economic Life Salvage Value Tax Rate Cost of Capital Units Sold Sales Price Per Unit Incremental Cost Per Unit Inventory/sales Inflation rate $200,000 $10,000 $30,000 4 $25,000 40% 10% 1250 $200 $100 12% 3%

750 $108.07 x Basis $240.500 $128.680 e.45 0.800 c.612 $38.200 $106.000 $36.480 $79. Estimate the required net operating working capital for each year.09 $265. After-tax Salvage Value Salvage Value Tax on Salvage Value $25.33 0. Construct annual incremental operating cash flow statements.500 $31. Annual Cash Flows due to Investments in Net Operating Working Capital Year 0 Sales NOWC (% of sales) CF due to investment in NOWC) f.225 $32.000 $96.645 $57. and the cash flow due to investments in net operating working capital.000 $16.588 $16.450 Year 3 1250 $212.000 $10.15 0.000 Year 1 2 3 4 % 0.27 $273.000 $79. Disregard the assumptions in Part a.000 $120.00 $250.900 ($900) Year 2 $257.200 $108.800 $47.967 Year 4 1250 $218.800 $119.18 $106.b.827 ($927) Year 3 $265.967 $36.613 $36.000 $125.00 $100. Calculate the after-tax salvage cash flow.225 $132.000) Year 1 $250. Why is it important to include inflation when estimating cash flows? d.320 $27.188 $136.000 $240.188 $32.680 Year 2 1250 $206. $79.800 $18.00 $257.000 $20.000 = Depr.800 $88.450 $108.783 .920 $71.750 $8. Annual Operating Cash Flows Units Unit price Unit cost Sales Costs Depreciation Operating income before taxes (EBIT) Taxes (40%) Net operating profit after taxes Depreciation Net Operating CF Year 1 1250 $200.000 $240.880 $16. Calculate the annual sales revenues and costs (other than depreciation).000 $93.300 $12.000 ($30.200 $45. What is Shrieves' depreciable basis? What are the annual depreciation expenses? Annual Depreciation Expense Depreciable Basis = Equipment + freight + installation Depreciable Basis = $240.00 $103.000 $30.000 $30.000 $240.55 $109.783 ($956) Year 4 $273.

5 1 ($270.Net Terminal Cash Flow $15.0% Find Payback 0 Cumulative Cash Flow for Payback Cum.680 ($900) $105. We use Excel to examine the project's sensitivity to changes in the input variables. But it is easier to use the MIRR function. if there were a high probability that the expected NPV as calculated above will actually turn out to be negative.011 ($240. to what extent can risk be quantified.000 g.5 h. because sales were lower than expected. In other words. judgmental estimates? Risk in capital budgeting really means the probability that the actual outcome will be worse than the expected outcome.9% $358. For example.220) FALSE FALSE 0 0 Years 2 ($44.030 23. Based on these cash flows.523 $93. or the project turned out to have a higher than expected initial cost. CF > 0. . What does the term ”risk” mean in the context of capital budgeting. IRR. and when risk is quantified. Calculate the net cash flows for each year.000) ($164.000) ($270. if the assumed inputs turn out to be worse than expected then the output will likewise be worse than expected.967 ($956) $93.523 3 $93.011 Year 1 Year 2 Year 3 Find MIRR Net Cash Flows 0 ($270.030 $524. hence Payback Year: Payback found with Excel function = Payback = 2.697) FALSE 0 3 $48. MIRR.780 2 $119.000) ($30. and payback? Do these indicators suggest that the project should be undertaken? Projected Net Cash Flows Year 0 Investment Outlay: Long Term Assets Operating Cash Flows CF due to investment in NOWC Salvage Cash Flows Net Cash Flows NPV IRR $88. we could now find the discount rate that equates the PV and TV.000) $106. MIRR = 18.000) PV= ($270. then the project would be classified as relatively risky.314 TRUE 2.780 $120. is the quantification based primarily on statistical analysis of historical data or on subjective.191 Years 1 $105. costs were higher than expected. typically.450 ($927) $119. what are the project’s NPV. The reason for a worse-than-expected outcome is.000) TV = To find MIRR.

500. and cost of capital for the project.000 $100. if the assumed inputs turn out to be worse than expected then the output will likewise be worse than expected.0% % Deviation 1st YEAR UNIT SALES % Deviation NPV from Units NPV from 88.250.000 $0 -50% -40% -30% -20% -10% Column C Column D Column E 0% 10% 20% 30% 40% Deviation from Base-Case Value .00 $32.348 -15% $88.392 30% SALVAGE Variable Cost $17. i. after inputting the values for WACC in cells B205:B209 and the formula =C105 for NPV in cell C204.030 0% $76. costs were higher than expected. The reason for a worse-than-expected outcome is.) What is sensitivity analysis? Answer:See Chapter 11 Mini Case Show (2. or the project turned out to have a higher than expected initial cost.0% 11.00 $28.00 $25.5% 10. salvage value. and graphed the most sensitive items in the following chart: % Deviation from Base Case -30% -15% 0% 15% 30% WACC WACC 7.625 $159.288 -30% 875 $16.310 -15% 1. (1.030 Base Case $113. Assume that each of these variables can vary from its base case. (1. We summarize the data tables. This produces the sensitivity analysis for WACC as shown below.) Perform a sensitivity analysis on the unit sales.5% 13.030 0% 1. For example.250 $88. For example.063 $52. and discuss the results. In other words. if there were a high probability that the expected NPV as calculated above will actually turn out to be negative.000 $40.00 $21. and enter D31 (which is the input for WACC) as the Column input.000 NPV $60. because sales were lower than expected. or expected. arranged by sensitivity. typically.000. 20.) How is each type of risk used in the capital budgeting process? Answer: See Chapter 11 Mini Case Show Evaluating Risk: Sensitivity Analysis Sensitivity of NPV and to Variations in Unit Sales.000 $20. select the range B204:C209.750.) How is each of these risk types measured. Here we use an Excel "Data Table" to find NPV different unit sales.500. Table. Then choose from the menu Data.371 30% 1.Risk in capital budgeting really means the probability that the actual outcome will be worse than the expected outcome.668 -30% $100. We use Excel to examine the project's sensitivity to changes in the input variables.000 $80. then the project would be classified as relatively risky. and 30 percent. value by plus and minus 10.0% 8.00 Evaluating Risk: Sensitivity Analysis Sensitivity Analysis $120. holding other thing constant.398 15% 1.) What are the three types of risk that are relevant in capital budgeting? Answer: See Chapter 11 Mini Case Show (2.438 $123.030 Base Case Sold $88. j.711 15% $65. Include a sensitivity diagram. and how do they relate to one another? Answer: See Chapter 11 Mini Case Show (3.

030 $100. a 25 percent chance of excellent acceptance. we could use Tools. standard deviation. This is a powerful feature of Excel.348 $88.) What is the worst-case NPV? The best-case NPV? (3.) What is the primary weakness of sensitivity analysis? What is its primary usefulness? Answer: See Chapter 11 Mini Case Show k. and it will automatically create a table similar to the one below. hence to see the combined effects of changes in several variables on NPV.000 $0 -50% -40% -30% -20% -10% Column C Column D Column E 0% 10% 20% 30% 40% Deviation from Base-Case Value Deviation from Base Case -30% -15% 0% 15% 30% Range NPV Deviation from Base Case Units WACC Sold Salvage $113.288 $16.711 $88.030 47.371 $159. (1.030 $88. which we did.030 $76. and then click the Summary button on the dialog box. you could even use Tools.398 $123. and a 50 percent chance of average acceptance (the base case). and best-case NPVs and probabilities of occurrence to find the project’s expected NPV. In fact.030 $88.916 176.) Use the worst-. Alternatively. most likely. Sidney believes that there is a 25 percent chance of poor acceptance. Scenarios to define the inputs for each scenario. Assume that Sidney Johnson is confident of her estimates of all the variables that affect the project’s cash flows except unit sales and sales price: If product acceptance is poor. unit sales would be only 900 units a year and the unit price would only be $160.000 $20.) What is scenario analysis? Scenario analysis extends risk analysis in two ways: (1) It allows us to change more than one variable at a time. a strong consumer response would produce sales of 1. and coefficient of variation. Scenarios.060 0 -30% -15% 0% 15% 30% $113 $100 $88 $76 $65 (3.000 NPV $60. and we encourage you to explore it. (2. We could find the NPV by entering the value of unit sales and price for each scenario and then recording the NPV (this is what we did for the table below). and (2) It allows us to bring in the probabilities of to see the combined effects of changes in several variables on NPV.$80. and (2) It allows us to bring in the probabilities of changes in the key variables.030 $88.030 $65. Evaluating Risk: Scenario Analysis Scenario Analysis Squared Deviation .392 $88.310 $52.000 $40.600 units and a unit price of $240.668 $88.

088. you will need to install the Excel Add-In Simtools. To use this spreadsheet.542.612. and discuss its principal advantages and disadvantages.111.358. Answer: See Chapter 11 Mini Case Show Monte Carlo Simulation Monte Carlo simulation is similar to scenario analysis in that different values of key inputs are input. See the file Explanation of Simulation.43 $101.371 (See the +30% WACC in the sensitivity analysis above.) Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk. or even thousands. (1.635. See the file FM11 Ch 11 Mini Case Simulation.514) $5.Scenario Best Case Base Case Worst Case Probability 25% 50% 25% Unit Sales 1600 1250 900 Unit Price $240 $200 $160 NPV times probability $278.030 $92.628 $75. Risk Adjusted Cost of Capital m. Unlike scenario analysis. Should the new furniture line be accepted? Cost of capital for average projects: Adjustment for risky projects: Risk adjusted cost of capital: NPV with risk adjusted cost of capital: 10% 3% 13% $65.2 – 0.965 $7.xla. Would the new furniture line be classified as high risk.684 0. of times.450.862.74 Expected NPV = Standard Deviation = Coefficient of Variation = Std Dev / Expected NPV = l.79 $88. or low risk? What type of risk is being measured here? Answer: See Chapter 11 Mini Case Show (2. This project is riskier than the firm's average project. Monte Carlo simulation draws the input values from a specified probability distribution and then computes the NPV. It repeats this process hundred.) Assume that Shrieves' average project has a coefficient of variation in the range of 0. so he adds 3 points.doc for an explanation of how to install the Add-In. Are there problems with scenario analysis? Define simulation analysis.xls for a detailed example.34 ($48.) (3.4. It then averages the NPVs from each repetition. average risk.) Are there any subjective risk factors that should be considered before the final decision is made? Answer: See Chapter 11 Mini Case Show .

000 per year.000 in shipping machinery has an t in the MACRS 3-year ental cost of $100 per unit s price and cost are et operating working s 40 percent. and its wer: See Chapter 11 Mini ld this be included in the uld this be included in the es by $50. .dgeting analysis is being n unused space in 10.

al depreciation expenses? include inflation when estments in net operating .

typically. and when risk ubjective. IRR.783 $15. For urn out to be negative.463 4 $136.463 $102. 4 $184.793 $524.000 $136.191 o use the MIRR function. come is. and Year 4 $88. because a higher than expected put will likewise be worse .777 FALSE 0 quantified. MIRR.680 $32.PV. judgmental the expected outcome.312 $144.623 $140.

after elect the range C) as the Column input.030 $88.030 $88.030 $88.030 $88.030 Column C Column D Column E .030 $88.er 11 Mini Case Show See Chapter 11 Mini Case ni Case Show oject. Assume that each of rcent. e following chart: SALVAGE NPV $88. Include a For example.

Column C Column D Column E $17 ### $52 ### $88 ### $124 ### $159 ### wer: See Chapter 11 Mini oject’s cash flows except and the unit price would 240. and it will encourage you to explore . which ialog box. cording the NPV (this is for each scenario. Sidney believes that a 50 percent chance of ble at a time. hence to see robabilities of to see the abilities of changes in the project’s expected NPV.

l advantages and put. Unlike scenario and then computes the om each repetition. Would the new ured here? Answer: See ust for risk. .) made? Answer: See . See will need to install the install the Add-In. This project epted? alysis above.4.

Base Case 1250 200 Page 13 .

Best Case 1600 240 Page 14 .

Worst Case 900 160 Page 15 .

3% 1.514) $C$110 23.Scenario Summary Current Values: Base Case Best Case Worst Case Changing Cells: $D$31 1250 1250 1600 900 $D$32 $200 $200 $240 $160 Result Cells: $C$109 $88.9% 23.030 $88.030 $278.0% Notes: Current Values column represents values of changing cells at time Scenario Summary Report was created.9% 48. .965 ($48. Changing cells for each scenario are highlighted in gray.

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