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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: This is the firm’s cash flow with the project minus the firm’s cash flow without the project. a. 1. Should you subtract interest expense or dividends when calculating project cash flow?
Answer: The cash flow statement should not include interest expense or dividends. The return required by the investors furnishing the capital is already accounted for when we apply the 10 percent cost of capital discount rate, hence including financing flows would be "double counting." Put another way, if we deducted capital costs in the table, and thus reduced the bottom line cash flows, and then discounted those CFS by the cost of capital, we would, in effect, be subtracting capital costs twice. a. 2. Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this cost be included in the analysis? Explain.
Mini Case: 11 - 1
000 annual outflow.2 . a 3-year project is depreciated over 4 calendar years: YEAR 1 2 3 4 RATE 0. Since. then the net cash flow loss would be a cost to the project. then if Shrieves accepts this project. Should this be included in the analysis? If so. Now assume that the plant space could be leased out to another firm at $25. this is an "externality" which must be considered in the analysis.000 per year. Note that this annual loss would not be the full $50.000 in annual cash flows. how? Answer: If the plant space could be leased out to another firm.07 × BASIS $240 240 240 240 = DEPRECIATION $ 79 108 36 17 $240 Mini Case: 11 . it is a sunk cost. This represents an opportunity cost to the project. 4.000 a year. What is Shrieves’ depreciable basis? Answer: Get the depreciation rates from table 11-2 in the book. a.000. 3.6) = $15.Answer: The $100. b. If the firm's sales would be reduced by $50. Note that because of the halfyear convention. how? Answer: If a project affects the cash flows of another project. it should not be included in the analysis. a.15 0.t) = $25. because Shrieves would save on cash operating costs if its sales dropped. and presumably also expensed for tax purposes.000(1 . Finally.000(0.000 cost to rehabilitate the production line site was incurred last year. Should this be considered in the analysis? If so. assume that the new product line is expected to decrease sales of the firm’s other lines by $50. it would forgo the opportunity to receive $25. Disregard the assumptions in part a. Note also that externalities can be positive as well as negative. and it should be included in the analysis. Note that the opportunity cost cash flow must be net of taxes.33 0.45 0.000. so it would be a $25.
00 $257. c.000 Year 2 1250 $206. Similarly. Therefore.18 $106. you could do either way and get the correct answer. you should always discount nominal cash flows with a nominal rate. However. then the resulting NPV is too low.613 $136.. Why is it important to include inflation when estimating cash flows? Answer: With an inflation rate of 3%. Why is it important to include inflation when estimating cash flows? Answer: With an inflation rate of 3%. Calculate the annual sales revenues and costs (other than depreciation).27 $265. the annual revenues and costs are: Here are the annual operating cash flows (in thousands of dollars): Net Revenues Depreciation Before-Tax Income Taxes (40%) Net Income Plus Depreciation Net Operating CF 1 $125 79 $ 46 18 $ 28 79 $107 2 $125 108 $ 17 7 $ 10 108 $118 3 $125 36 $ 89 36 $ 53 36 $ 89 4 $125 17 $108 43 $ 65 17 $ 82 Mini Case: 11 . In theory. and real cash flows with a real rate.e.188 $132.c. it is larger than the real cost of capital.00 $100. nominal rate.225 $273.588 The cost of capital is a nominal cost. i.3 . the annual revenues and costs are: Units Unit Price Unit Cost Sales Costs Year 1 1250 $200. Calculate the annual sales revenues and costs (other than depreciation). In other words. it includes a premium for inflation.09 Year 4 1250 $218.000 $125.55 $109.00 $103. real cash flows with the high. nominal cash flows (those that are inflated) are larger than real cash flows. you should inflate cash flows and then discount at the nominal rate. there is no accurate way to convert a nominal cost of capital to a real cost.00 $250.750 Year 3 1250 $212. If you discount the low. Therefore.500 $128.
and any decrease is a positive cash flow.800 $38. EBIT Taxes (40%) NOPAT Depreciation Net Operating CF e.320 $27.d. Estimate the required net operating working capital for each year.680 Year 2 $257. Answer: When the project is terminated at the end of year 4.000 $120. Any increase in NOWC is a negative cash flow. Year 1 $250. taxes must be paid on the full salvage value.4 .000 (10.500 $31.500 $128.967 $88.000 $16.588 $36.000) $15.188 $32.920 $57.450 Year 3 Year 4 $265.783 Calculate the after-tax salvage cash flow.450 $108.612 $119.200 $106. the equipment can be sold for $25.967 $71.000) Year 1 $250.750 $108.000 $125.225 $273.750 $8.800 $96.000 Mini Case: 11 . Answer: Construct annual incremental operating cash flow statements.827 ($927) Year 3 Year 4 $265.188 $132. Year 0 Sales NOWC (% of sales) CF due to NOWC) f.300 $12.680 Sales Costs Depreciation Op.645 $47.000 $16. Answer: The project requires a level of net operating working capital in the amount equal to 12% of the next year’s sales.613 $136.880 $36.000 $79.800 $93.900 ($900) Year 2 $257. since it has been depreciated to a $0 book value. the after-tax salvage cash flow is: Salvage Value Tax On Salvage Value Net After-Tax Salvage Cash Flow $25. and the cash flow due to investments in net operating working capital.783 $0 ($956) $32. $30.800 $18.480 $79.225 $273. But.000 $30.000. For this project.000 $20.200 $45.000 ($30.
Mini Case: 11 .967 ($927) ($956) $119. a company that is considering going into a new business might be able to look at historical data on existing firms in that industry to get an idea about the riskiness of its proposed investment. but you must recognize at the outset that some of the data used in the analysis will necessarily be based on subjective judgments rather than on hard statistical observations. However.780 Year 2 Year 3 Year 4 $88. and when risk is quantified. manufacturing.9% 18.463 $120. if Sears were opening a new store.000) ($270. if Citibank were opening a new branch.680 $32. or if GM were expanding its Chevrolet plant.000 $136. then past experience could be a useful guide to future risk. $88. for example. Calculate the net cash flows for each year? Based on these cash flows.523 $93. there are times when it is impossible to obtain historical data regarding proposed investments.0% 2. We will try to quantify risk analysis.011 NPV = IRR = MIRR = Payback = h.000) Year 1 $106.5 What does the term “risk” mean in the context of capital budgeting. and payback? Do these indicators suggest that the project should be undertaken? Answer: The net cash flows are: Initial Outlay Operating Cash Flows CF Due To NOWC Salvage Cash Flows Net Cash Flows Year 0 ($240. not much relevant historical data for assessing the riskiness of the project would be available. and in capital budgeting.450 $93.680 ($900) $105. MIRR. Rather. this means the future profitability of a project. GM would have to rely primarily on the judgment of its executives. Similarly. in turn would have to rely on their experience in developing. and they. to what extent can risk be quantified. This is often true when the investment involves an expansion decision.g.783 $15. what are the project’s NPV. it is possible to look back at historical data and to statistically analyze the riskiness of the investment. for example.000) ($30.5 . For certain types of projects. is the quantification based primarily on statistical analysis of historical data or on subjective. judgmental estimates? Answer: Risk throughout finance relates to uncertainty about future events.030 23. IRR. if GM were considering the development of an electric auto. and marketing new products.
and how do they relate to one another? Answer: Here are the three types of project risk: • Stand-alone risk is the project’s total risk if it were operated independently. • • i. that is. However. Thus. It is measured by the project’s market beta. How is each type of risk used in the capital budgeting process? Answer: Because management’s primary goal is shareholder wealth maximization. a project’s within-firm risk should not be completely ignored. which is the slope of the regression line formed by plotting returns on the project versus returns on the market. 1.i. It is the contribution of the project to the firm’s total risk. Stand-alone risk is measured either by the project’s standard deviation of NPV (σNPV) or its coefficient of variation of NPV (CVNPV). a project’s stand-alone risk is likely to be highly correlated with its within-firm risk. Note that other profitability measures. Within-firm risk is the total riskiness of the project giving consideration to the firm’s other projects. How is each of these risk types measured. creditors. Mini Case: 11 . such as IRR and MIRR. and employees are all affected by a firm’s total risk. and it is a function of (a) the project’s standard deviation of NPV and (b) the correlation of the projects’ returns with those of the rest of the firm. Since these parties influence the firm’s profitability. the most relevant risk for capital projects is market risk. which in turn is likely to be highly correlated with its market risk. customers. In this situation. this focus does not necessarily lead to poor decisions. can also be used to obtain stand-alone risk estimates. to diversification within the firm. Market risk is the riskiness of the project to a well-diversified investor. firms often focus on this type of risk when making capital budgeting decisions. and it is measured by the project’s corporate beta. What are the three types of risk that are relevant in capital budgeting? 2. hence it considers the diversification inherent in stockholders’ portfolios. by far the easiest type of risk to measure is a project’s stand-alone risk. Standalone risk ignores both the firm’s diversification among projects and investors’ diversification among firms.6 . because most projects that a firm undertakes are in its core business. However. which is the slope of the regression line formed by plotting returns on the project versus returns on the firm. suppliers. 3. Unfortunately. Within-firm risk is often called corporate risk.
What is sensitivity analysis? Answer: Sensitivity analysis measures the effect of changes in a particular variable. and the resulting effect on NPV is noted. say revenues. and discuss the results.103 6.956 $86.310 $88. 20. often by specified percentages. To perform a sensitivity analysis.916 Units Sold $16.398 $65. Answer: The sensitivity data are given here in tabular form (in thousands of dollars): NPV Deviation From Base Case Deviation From Base Case -30% -15% 0% 15% 30% Range WACC $113. This one variable is then changed. and 30 percent.j. Perform a sensitivity analysis on the unit sales.030 $123.567 $91.668 $52. salvage value. Include a sensitivity diagram.392 176. but this then merges sensitivity analysis into scenario analysis. 1.7 . on a project’s NPV.) j.030 $89. all variables are fixed at their expected values except one.711 $159. and cost of capital for the project. Assume that each of these variables can vary from its base case.060 Salvage $84. or expected.288 $100.371 47.147 Mini Case: 11 . value by plus and minus 10. 2.493 $88.348 $88.030 $76. (One could allow more than one variable to change.
000 $120.000 $100. or expected values. Conversely.000 $160.We generated these data with a spreadsheet model in the file ch 11 mini case.573.000 $20.000 $80. The plot of unit sales is much steeper than that for salvage value.000 $140. B. because a higher cost of capital leads to a lower NPV. The plots for unit sales and salvage value are upward sloping. the plot for cost of capital is downward sloping.xls.000 $0 -40% NPV WACC Units Sold Salvage -20% 0% 20% 40% Deviation from Base-Case Value A. Since all other variables are set at their base case.000 $60. indicating that higher variable values lead to higher NPVs. Mini Case: 11 .8 . C.000 $40. The sensitivity lines intersect at 0% change and the base case NPV. $81. Sensitivity Analysis $180. the zero change situation is the base case. This indicates that NPV is more sensitive to changes in unit sales than to changes in salvage value.
the one with the steeper lines is considered to be riskier. most likely case. j. are fixed by a longterm contract. hence that the project is quite risky. such as unit sales and sales price. 3.9 . hence its revenues. What is scenario analysis? k. and this helps management focus its attention on those variables that are probably most important. and a 50 percent chance of average acceptance (the base case). then sales variations may actually contribute little to the project’s risk. 1. in many situations. a sensitivity analysis might indicate that a project’s NPV is highly sensitive to the sales forecast. Sidney believes that there is a 25 percent chance of poor acceptance. Therefore. What is the primary weakness of sensitivity analysis? What is its primary usefulness? Answer: The two primary disadvantages of sensitivity analysis are (1) that it does not reflect the effects of diversification and (2) that it does not incorporate any information about the possible magnitudes of the forecast errors. However. It provides a range of possible outcomes. a strong consumer response would produce sales of 1. in comparing two projects. Steeper sensitivity lines indicate greater risk. Answer: Scenario analysis examines several possible situations.600 units and a unit price of $240. 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. Mini Case: 11 . k. sensitivity analysis is not a particularly good indicator of risk. unit sales would be only 900 units a year and the unit price would only be $160. but if the project’s sales.D. Thus. sensitivity analysis does identify those variables which potentially have the greatest impact on profitability. and best case. a 25 percent chance of excellent acceptance. It also ignores any relationships between variables. Thus. usually worst case.
2. and coefficient of variation. What is the worst-case NPV? The best-case NPV? 3. Use the worst-.514) $101.965 $88. Answer: We used a spreadsheet model to develop the scenarios (in thousands of dollars). which are summarized below: Scenario Best Case Base Case Worst Case Probability 25% 50% 25% Unit Sales 1600 1250 900 Unit Price $240 $200 $160 Expected NPV = Standard Deviation = Coefficient Of Variation = Std Dev / Expected NPV = NPV $278.684 0.628 $75.10 . k.k. most likely. standard deviation.030 ($48.74 Mini Case: 11 . and best-case NPVs and probabilities of occurrence to find the project’s expected NPV.
average risk. and simulation analyses all focus on stand-alone risk. Simulation analysis is a type of scenario analysis which uses a relatively powerful financial planning software such as interactive financial planning system (IFPs) or @risk (a spreadsheet add-in). Simulation provides the decision maker with a better idea of the profitability of a project than does scenario analysis because it incorporates many more possible outcomes. Here the uncertain cash flow variables (such as unit sales) are entered as continuous probability distribution parameters rather than as point values. m. with new values selected from the distributions for each run.000. Simple simulations can also be conducted with other spreadsheet add-ins. scenario. The software can graph the distribution as well as print out summary statistics such as expected NPV and σ NPV. and discuss its principal advantages and disadvantages. Answer: Scenario analysis examines several possible scenarios. 1.11 .4. the correlations among the uncertain variables must be specified. then the results of simulation analyses are of limited value. nor simulation analysis provides a decision rule--they may indicate that a project is relatively risky. which is not the most relevant risk in capital budgeting analysis. The CV measures a project’s stand-alone risk-it is merely a measure of the variability of returns (as measured by NPV) about the expected return. Mini Case: 11 .000 values. which is above the average range of 0. Although simulation analysis is technically refined. Obviously the world is much more complex. Finally.l. Are there problems with scenario analysis? Define simulation analysis. remember that sensitivity. say 1.57. Thus.4. or low risk? What type of risk is being measured here? Answer: The project has a CV of 0. The process is repeated many times. Once all of the variable values have been selected. Would the new line be classified as high risk. along with the correlations over time. so it falls into the high risk category. Further. Recognize also that neither sensitivity. the computer uses a random number generator to select values for the uncertain variables on the basis of their designated distributions. but they do not indicate whether the project’s expected return is sufficient to compensate for its risk. its usefulness is limited because managers are often unable to accurately specify the variables’ probability distributions.2-0. most likely case. The end result is a probability distribution of NPV based on a sample of 1.2-0. scenario. Then. and most projects have an almost infinite number of possible outcomes. and an NPV is calculated. they are combined. usually worst case. and best case. Assume that Shrieves’ average project has a coefficient of variation in the range of 0. such as Simtools. If managers are unable to do this with much confidence. it usually considers only 3 possible outcomes.
cost of capital would be 13 percent.m. Mini Case: 11 . Also. m.12 .975. At this discount rate. then. its NPV would be $60. Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk. If it were a low risk project. so it would still be acceptable.” the project may be less risky than the analysis indicates. then it might be riskier than first assessed. its cost of capital would be 7 percent.541. Are there any subjective risk factors that should be considered before the final decision is made? Answer: A numerical analysis such as this one may not capture all of the risk factors inherent in the project. if the project’s assets can be redeployed within the firm or can be easily sold. 3. and it would be an even more profitable project on a risk-adjusted basis. its differential risk-adjusted. or project. its NPV would be $104. If the project has a potential for bringing on harmful lawsuits. 2. as a result of “abandonment possibilities. Should the new furniture line be accepted? Answer: Since the project is judged to have above-average risk.
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