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1/1/2012

Chapter 11 Mini Case


Cash Flow Estimation 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 machinerys 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 expected to increase by 3% per year due to inflation. Further, to handle the new line, the firms net working capital would have to increase by an amount equal to 12% of sales revenues. The firms tax rate is 40%, and its overall weighted average cost of capital is 10%. a. Define incremental cash flow.

(1.) Should you subtract interest expense or dividends when calculating project cash flow? (2.) Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain. (3.) Now assume that the plant space could be leased out to another firm at $25,000 per year. Should this be included in the analysis? If so, how?

(4.) Finally, assume that the new product line is expected to decrease sales of the firms other lines by $50,000 per year. Should this be considered in the analysis? If so, how? 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 NWC/Sales Inflation rate Key Output: NPV = $0

b. Disregard the assumptions in Part a. What is Shrieves' depreciable basis? What are the annual depreciation expenses? Annual Depreciation Expense Depreciable Basis = Equipment + Freight + Installation Depreciable Basis = $0 Remaining Book Value $0 0 0 0

Year 1 2 3 4

% 0.33 0.45 0.15 0.07

Basis $0 0 0 0

Depr. $0 0 0 0

c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows? d. Construct annual incremental operating cash flow statements. Annual Operating Cash Flows Year 1 Units Unit price Unit cost Sales Costs Depreciation Operating income before taxes (EBIT) Taxes (40%) EBIT (1 T) Depreciation Net operating CF 0 $0.00 $0.00 $0 0 0 $0 0 $0 0 $0 Year 2 0 $0.00 $0.00 $0 0 0 $0 0 $0 0 $0 Year 3 0 $0.00 $0.00 $0 0 0 $0 0 $0 0 $0 Year 4 0 $0.00 $0.00 $0 0 0 $0 0 $0 0 $0

e. Estimate the required net working capital for each year, and the cash flow due to investments in net working capital. Annual Cash Flows due to Investments in Net Working Capital Year 0 Sales NWC (% of sales) CF due to investment in NOWC) 0 0 Year 1 $0 0 0 Year 2 $0 0 0 Year 3 $0 0 0 Year 4 $0 0

f. Calculate the after-tax salvage cash flow. After-tax Salvage Value Based on facts in case: $0 0 $0 0 $0 Hypothetical: If sold after 3 years for

Salvage value Book value Gain or loss Tax on salvage value Net terminal cash flow

g. Calculate the net cash flows for each year. Based on these cash flows, what are the projects NPV, IRR, MIRR, and payback? Do these indicators suggest the project should be undertaken?

Projected Net Cash Flows


Year 0 Investment Outlay: Long Term Assets Operating Cash Flows CF due to investment in NWC Salvage Cash Flows Net Cash Flows NPV IRR $0 #NUM! $0 0 $0 $0 0 $0 $0 0 $0 $0 0 $0 $0 0 0 $0 Year 1 Year 2 Year 3 Year 4

PV of InflowsTV of Inflows $0 $0 Years 0 $0 1 $0 2 $0 3 $0 4 $0 0 0 0 $0

Find MIRR
Net Cash Flows

PV=

$0

TV =

To find MIRR, we could now find the discount rate that equates the PV and TV. But it is easier to use the MIRR function. MIRR = #DIV/0!

Find Payback
Cash Flow Cumulative Cash Flow for Payback Payback = 0.0 0 $0 $0 1 $0 $0

Years 2 $0 $0

3 $0 $0

4 $0 $0

h. What does the term risk mean in the context of capital budgeting; to what extent can risk be quantified; and when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates? Risk in capital budgeting really means the probability that the actual outcome will be worse than the expected outcome. For example, if there were a high probability that the expected NPV as calculated above will actually turn out to be negative, then the project would be classified as relatively risky. The reason for a worse-than-expected outcome is, typically, because sales were lower than expected, costs were higher than expected, and/or the project turned out to have a higher than expected initial cost. In other words, if the assumed inputs turn out to be worse than expected then the output will likewise be worse than expected. We use Excel to examine the project's sensitivity to changes in the input variables.

i. (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?

Evaluating Risk: Sensitivity Analysis


Sensitivity of NPV and to Variations in Input Variables j. (1.) What is sensitivity analysis? (2.) Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the project. Assume that each of these variables can vary from its base-case, or expected, value by plus and minus 10%, 20%, and 30%. Include a sensitivity diagram, and discuss the results. Here we use an Excel "Data Table" to find the NPVs for changes in unit sales, salvage value, and WACC holding other things constant--changing one variable at a time. This produces the sensitivity analys as shown below. We summarize the data tables and show the sensitivity analysis graph below: % Deviation from Base Case -30% -15% 0% 15% 30% WACC WACC NPV 0 $0 0 0 0 0 % Deviation 1st YEAR UNIT SALES % Deviation SALVAGE from Units NPV from Variable NPV Base Case Sold $0 Base Case Cost $0 -30% $0 -30% $0 -15% 0 -15% 0 0% 0 0% 0 15% 0 15% 0 30% 0 30% 0

Evaluating Risk: Sensitivity Analysis


NPV ($) 1 1 1 1 1 1 0 0 0 0 0 -40%

Sensitivity Analysis

Units Sold

Salvage Value

WACC

-20%

0%

20%

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 $0 $0 $0 0 0 0 0 0 0 0 0 0 0 0 0 $0 $0 $0

(3.) What is the primary weakness of sensitivity analysis? What is its primary usefulness? k. Assume that Sidney Johnson is confident of her estimates of all the variables that affect the projects 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; a strong consumer response would produce sales of 1,600 units and a unit price of $240. Sidney believes that there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case). (1.) 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, hence to see the combined effects of changes in several variables on NPV, and (2) it allows us to bring in the probabilities of changes in the key variables. (2.) What is the worst-case NPV? The best-case NPV? (3.) Use the worst-, most likely, and best-case NPVs and probabilities of occurrence to find the projects expected NPV, standard deviation, and coefficient of variation.

Evaluating Risk: Scenario Analysis


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). Alternatively, we could use Tools, Scenarios to define the inputs for each scenario, which we did and show in the Scenario Summary Tab below. In fact, you could even use Tools, Scenarios, and then click the Summary button on the dialog box, and it will automatically create a table similar to the one below. This is a powerful feature of Excel, and we encourage you to explore it.

Scenario Analysis
Scenario Best Case Base Case Worst Case Probability 25% 50% 25% $0 $0 #DIV/0! Quick calculation: $0 $0 Unit Sales Unit Price NPV Squared Deviation times Probability

Expected NPV = Standard Deviation = Coefficient of Variation = Std Dev / Expected NPV =

l. Are there problems with scenario analysis? Define simulation analysis, and discuss its principal advantages and disadvantages.

Monte Carlo Simulation


Monte Carlo simulation is similar to scenario analysis in that different values of key input variables are used. Unlike scenario analysis, Monte Carlo simulation draws the input values from specified probability distributions and then computes the NPV. It repeats this process hundreds, or even thousands, of times. It then averages the NPVs from each repetition.

Risk Adjusted Cost of Capital


m. (1.) Assume that Shrieves' average project has a coefficient of variation in the range of 0.2 to 0.4. Would the new line be classified as high risk, average risk, or low risk? What type of risk is being measured here?

(2.) Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk. Should the new line be accepted? The CV of this project is 1.15, which is larger than the CV range of the firm's average project. Consequently, this project is riskier than the firm's average project, so management should add 3% to the WACC to risk adjust. Cost of capital for average projects: Adjustment for risky projects: Risk adjusted cost of capital: NPV with risk-adjusted cost of capital: 0%

$0

(3.) Are there any subjective risk factors that should be considered before the final decision is made? m. What is a real option? What are some types of real options?

Scenario Summary
Current Values: Base Case Best Case

Changing Cells: $D$36 $200,000 $200,000 $D$37 $10,000 $10,000 $D$38 $30,000 $30,000 $D$39 4 4 $D$40 $25,000 $25,000 $D$41 40% 40% $D$42 10% 10% $D$43 1,250 1,250 $D$44 $200 $200 $D$45 $100 $100 $D$46 12% 12% $D$47 3% 3% Result Cells: $C$113 $88,030 $88,030 $C$114 23.9% 23.9% Notes: Current Values column represents values of changing cells at time Scenario Summary Report was created. Changing cells for each scenario are highlighted in gray.

$200,000 $10,000 $30,000 4 $25,000 40% 10% 1,600 $240 $100 12% 3% $278,965 48.3%

Worst Case

Base-but forget inflation

$200,000 $10,000 $30,000 4 $25,000 40% 10% 900 $160 $100 12% 3% ($48,514) 1.0%

$200,000 $10,000 $30,000 4 $25,000 40% 10% 1,250 $200 $100 12% 0% $78,387 22.7%

Section 11.7 Scenario Analysis


Monte Carlo simulation is similar to scenario analysis in that different values of key inputs are used Unlike scenario analysis, Monte Carlo simulation draws a trial set of input values from specified probability distributions and then computes the NPV for this trial. This process is repeated for hundreds, or even thousands, of trials, with key results (like NPV) saved from each trial. After running the number of desired trials, the NPVs from the trials can be averaged estimate the project's expected NPV; the trial results can also be used to provide a histogram showing the project's possible outcomes.

The green area below is the same project as in the mini case, but we have replaced the inputs fro units sold and sales price with random variables drawn from normal distributions with the expected values and means shown next to the inputs. Notice that each time the sheet makes a calculation, the values for unit sales, sales price, and NPV change (Hin you can make the sheet calculate by hitting the F9 key).

Here is a tip for simulating a project analysis. If you have already done the analysis and it is in a different worksheet, s how many rows it takes. Delete the green area below and add enough rows so that there will be room for your previou analysis. For example, this model was in the "Model" tab in the file Ch 11 Mini Case.xls , rows 33-132. We went into tha file, selected Rows 32-135, copied them, and then pasted them into Rows 32-135 of this Worksheet. Because we paste them into the same row numbers from which we copied them, all the formula references remained correct. We then edited this worksheet.

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 NWC/Sales Inflation rate $200,000 $10,000 $30,000 4 $25,000 40% 10% 1,687 $217 $100 12% 3% Key Output: NPV =

Random variable = Random variable =

Expected Value Std. Dev. 1,250 200 $200 $30

b. Disregard the assumptions in Part a. What is Shrieves' depreciable basis? What are the annual Annual Depreciation Expense Depreciable Basis = Equipment + Freight + Installation Depreciable Basis = $240,000

Year

Basis

Depr.

1 2 3 4

0.33 0.45 0.15 0.07

$240,000 240,000 240,000 240,000

$79,200 108,000 36,000 16,800

c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows? See answer to part d. d. Construct annual incremental operating cash flow statements. Annual Operating Cash Flows Units Unit price Unit cost Sales Costs Depreciation Operating income before taxes (EBIT) Taxes (40%) EBIT (1 T) Depreciation Net operating CF Year 1 1,687 $217.19 $100.00 $366,323 168,667 79,200 $118,456 47,382 $71,074 79,200 $150,274 Year 2 1,687 $223.70 $103.00 $377,312 173,727 108,000 $95,585 38,234 $57,351 108,000 $165,351 Year 3 1,687 $230.41 $106.09 $388,626 178,939 36,000 $173,687 69,475 $104,212 36,000 $140,212

e. Estimate the required net working capital for each year, and the cash flow due to investments in net working capital. Annual Cash Flows due to Investments in Net Working Capital Year 0 Sales NWC (% of sales) CF due to investment in NOWC) f. Calculate the after-tax salvage cash flow. After-tax Salvage Value Based on facts in case: $25,000 0 $25,000 10,000 $15,000 43,959 (43,959) Year 1 $366,323 45,277 (1,318) Year 2 $377,312 46,635 (1,358) Year 3 $388,626 48,034 (1,399)

Hypothetical: If sold $25,000 $25,000 16,800 $8,200 3,280 $21,720 $10,000 $10,000 16,800 ($6,800) (2,720) $12,720

Salvage value Book value Gain or loss Tax on salvage value Net terminal cash flow

g. Calculate the net cash flows for each year. Based on these cash flows, what are the projects NPV, IRR, MIRR, and payback? Do these indicators suggest the project should be undertaken?

Projected Net Cash Flows


Year 0 Year 1 Year 2

Investment Outlay: Long Term Assets Operating Cash Flows CF due to investment in NWC Salvage Cash Flows Net Cash Flows NPV IRR $227,431 41.9%

($240,000) (43,959) ($283,959) $150,274 (1,318) $148,956 $165,351 (1,358) $163,993

PV of Inflows TV of Inflows $511,390 $748,727 Years 0 ($283,959) 1 $148,956 2 $163,993

Find MIRR
Net Cash Flows

PV= ($283,959) To find MIRR, we could now find the discount rate that equates the PV and TV. But it is easier to use the MIRR function. MIRR = 27.4%

Find Payback
Cash Flow Cumulative Cash Flow for Payback Payback = 1.8 0 1 ($283,959) $148,956 ($283,959) ($135,003)

Years 2 $163,993 $28,990

How the Simulation Works

We use a Data Table to perform the simulation (the Data Table is below, shaded bright yellow). When the Data Table is updated, it will insert new random variables for each of the inputs we allow to change in Panel A above, run the analys is Panel C above, and then save the NPV for each trial (we also save the input variables for each trial so that we can verify that they are behaving as we expect). We set the first column of the Data Table (the variable to be changed in ea row) to numbers from 1-100. We don't really use these numbers anywhere in the analyis, but if we tell the Data Table t treat these as the Column inputs, Excel will recalculate all items in the Data Table, including the random inputs and th resulting NPV. In other words, we "trick" Excel into doing a simulation. We tell Excel to insert each of the Column inpu in the Data Table into the cell immediately below this box. This cell isn't linked to anything else, but each time Excel updates a row of the Data Table, all the random values will be updated. Column input cell to "trick" Excel into updating random variables in Data Table: 1

Excel normally updates all values in a Data Table each time any cell that is related to the Data Table changes. In our case, we have random variables in the Data Table, so each time any cell in the worksheet makes a calculation, the Dat Table is updated. If the Data Table has many rows, updating it can take up to 20 or 30 seconds. With only 100 rows, it updates very quickly. But if it bothers you, you can set the worksheet to do automatic calculation except for data table

You don't need to change anything in this section. It will be updated automatically if you do a simulation. The summa of the simulation results and the histogram are based on the simulation trials n the Data Table below and are updated automatically when you do a simulation. You can do an updated simulation by hitting the F9 key.

Figure 11-27 Summary of Simulation Results (Thousands of Dollars)


Number of Trials = 100 Simulated Input Variables and Key Results Sales Key Results: Price Per NPV Units Sold Unit $1,233 200 $85,065 215 30 $85,055 1,806 293 $370,409 805 139 -$58,834 $62,468 88.0% 1.00

Mean Standard deviation Maximum Minimum Median Probability of NPV > 0 Coefficient of variation

Probability

-370,409

-185,204

185,204

NPV ($)

Output of Simulation in Data Table


Trial Number 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 Units Sold 1,687 1432.6647 1168.8612 1323.7219 1515.111 995.37901 1445.0676 1457.0626 804.63361 1250.3167 1302.9828 1164.9934 1209.6255 1317.2792 1243.4634 956.23509 1647.6006 943.08585 1563.2695 1067.8494 1271.5684 906.14485 1302.2468 1216.6417 1345.4735 1107.7398 1082.281 1440.1969 1328.0367 1663.3224 1100.4895 1054.703 968.30493 1244.4503 1129.3061 1245.0807 1196.6139 925.00516 1377.1182 1332.1768 1280.1206 1271.4807 1212.0622 923.95643 Sales Price Per Unit $217 180.17496 226.01422 284.91757 158.54173 233.1371 236.75829 173.46777 180.78828 197.51061 165.46448 169.62372 176.2964 156.78288 292.5834 217.238 186.16309 193.91912 167.05784 220.65099 160.38797 228.83438 228.14002 168.48079 198.03664 192.20003 238.26262 205.31422 227.53295 201.79205 210.76554 155.28789 204.13976 238.85975 187.33163 237.39327 210.25094 203.03686 214.22875 187.02263 239.81736 209.01239 218.47309 197.81748 NPV $227,431 67614.0153 131656.653 320421.816 16462.0386 103653.165 228342.625 52328.7994 -26753.9516 82044.0619 10695.245 3103.96687 24641.7601 -9760.70275 310421.602 64146.7273 119405.216 18482.2056 47602.2495 96203.9688 -5713.73547 73348.9608 169152.728 7183.51369 101066.222 44177.6132 136552.227 139089.93 173907.822 172469.302 82591.2365 -40750.4116 42209.7398 180916.974 37266.5738 177536.445 101701.563 31636.2869 150288.688 70077.6235 192772.308 114372.878 124304.883 22062.1516

44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

1270.8344 1381.4714 1684.0121 1139.6029 1153.7962 905.41558 1238.8767 1327.4288 1121.7629 1027.0105 1375.0596 1168.0063 921.27421 1376.7343 1079.3413 1286.9886 1168.512 1486.8523 1660.0745 975.11106 1097.6706 897.76864 1280.0547 1022.5538 1192.1076 963.90388 1222.2166 1376.7497 1806.2153 1574.1531 1294.0386 1335.7207 921.62865 1144.2494 854.78119 1004.5466 1199.7377 1213.1649 1428.6648 1596.3323 1621.5454 1538.3123 1151.1236 1327.0252 1358.4665 886.80791 1144.5696 1370.6936 971.14663 1595.2374 973.34642 1164.1001

171.31922 161.95611 190.24278 242.34194 214.32831 192.1565 219.64378 252.90705 241.28072 204.8808 204.78048 187.08935 215.93717 233.61637 207.24426 139.37903 184.96361 231.84566 139.13524 211.22243 189.91704 164.21621 184.62427 168.23969 178.13487 187.6291 236.98464 188.49986 206.65771 223.88875 181.29288 173.66625 173.6675 224.60107 214.20035 198.95507 198.53083 253.71882 203.54086 180.06766 267.20103 160.79199 195.93881 174.10971 243.35026 186.81987 142.97133 220.21069 212.50851 204.16285 183.1489 195.18514

21183.1872 10948.2445 138697.8 160754.858 101833.762 8660.17868 133186.767 239193.159 153577.373 55332.4557 124595.129 43125.4028 53995.1696 202048.547 70746.9596 -56487.661 38392.5176 225088.843 -30213.2572 56977.5396 37534.9879 -41404.3778 55517.1378 -18341.5873 26372.5037 10422.7268 170554.466 81392.2157 217231.289 222761.707 49377.3987 36009.0227 -21607.2128 122589.453 36402.8533 39277.3818 75038.025 207619.574 131860.15 92116.8176 370408.704 25721.9302 60130.5677 35938.7743 223069.877 -3788.80466 -58833.9214 164809.509 58559.0422 166631.212 3516.17786 60789.9996

96 97 98 99 100

1373.4342 1211.4373 1191.0012 1071.9043 1400.169

161.24353 8108.00348 188.73508 54181.7168 156.19665 -24544.7452 195.34982 44457.7459 185.10464 76091.8882

1/1/2012

uts are used Unlike scenario bility distributions and then nds, of trials, with key results rom the trials can be averaged to ogram showing the project's

inputs fro units sold and sales and means shown next to the ales price, and NPV change (Hint:

d it is in a different worksheet, see e will be room for your previous , rows 33-132. We went into that Worksheet. Because we pasted s remained correct. We then

$227,431

ual

Remaining Book Value

$160,800 52,800 16,800 0

o include

Year 4 1,687 $237.32 $109.27 $400,281 184,303 16,800 $199,178 79,671 $119,507 16,800 $136,307

in net working

Year 4 $400,281 48,034

NPV, IRR,

Year 3

Year 4

$140,212 (1,399) $138,813

$136,307 48,034 15,000 $199,341

Years 3 $138,813 4 $199,341 152,695 198,432 198,260 $748,727

TV =

to use the MIRR function.

Years 3 $138,813 $167,803 4 $199,341 $367,144

yellow). When the Data Table is n Panel A above, run the analysis for each trial so that we can he variable to be changed in each s, but if we tell the Data Table to uding the random inputs and the insert each of the Column inputs ing else, but each time Excel

Don't change the the red cell.

e Data Table changes. In our et makes a calculation, the Data econds. With only 100 rows, it calculation except for data tables.

ou do a simulation. The summary a Table below and are updated he F9 key.

Scratch work for chart: see comments.

Count Range bottom -$370,409 -$343,951 -$317,493 -$291,035 -$264,578 -$238,120 -$211,662 -$185,204 -$158,747 -$132,289 -$105,831 -$79,373 -$52,916 -$26,458 $0 $26,458 $52,916 $79,373 $105,831 $132,289 $158,747 $185,204 $211,662 $238,120 $264,578 $291,035 $317,493 0 0 0 0 0 0 0 0 0 0 0 0 2 4 6 15 15 15 9 7 6 9 3 5 1 0 1 1 Percent 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 2% 4% 6% 15% 15% 15% 9% 7% 6% 9% 3% 5% 1% 0% 1% 1%

370,409

NPV ($)

$343,951 $370,409 Sum

1 0 100

1% 0% 100%