Tutorial Week 7 Solutions
(RTBWJ Chapter 9)

Question 1
Forecasting risk is the risk that a poor decision is made because of errors in projected cash
flows.
The danger is greatest with a new project because the cash flows are probably harder to
predict.

Question 2
With a sensitivity analysis, one variable is examined over a broad range of values. With a
scenario analysis, all variables are examined for a limited range of values.

Question 3

Question 4
The base-case, best-case, and worst-case values are shown below. Remember that in the best-
case, sales and price increase, while costs decrease. In the worst case, sales and price
decrease, and costs increase.

Scenario Unit Sales Unit Price
Unit
Variable Cost Fixed Costs
Base case 80,000 \$1,280 \$340 \$5,500,000
Best case 92,000 \$1,472 \$289 \$4,675,000
Worst case 68,000 \$1,088 \$391 \$6,325,000

Question 5
a. We will use the tax shield approach to calculate the OCF. The OCF is:

OCF
base
= [(P – v)Q – FC](1 – T
C
) + T
C
D
OCF
base
= [((\$36.50 – 22.75)(95,000)) – \$830,000](0.70) + 0.30(\$1,440,000/6)
OCF
base
= \$405,375

Now we can calculate the NPV using our base-case projections. There is no salvage value
or NWC, so the NPV is:

NPV
base
= –\$1,440,000 + \$405,375(PVIFA
13%,6
)
NPV
base
= \$180,506.75

To calculate the sensitivity of the NPV to changes in the quantity sold, we will calculate the
NPV at a different quantity. We will use sales of 100,000 units. The NPV at this sales level
is:

OCF
new
= [(\$36.50 – 22.75)(100,000) – \$830,000](0.70) + 0.30(\$1,440,000/6)
OCF
new
= \$453,500

And the NPV is:

NPV
new
= –\$1,440,000 + \$438,250(PVIFA
13%,6
)
NPV
new
= \$372,888.83

So, the change in NPV for every unit change in sales is:

∆NPV/∆S = [(\$180,506.75– 372,888.83)]/(95,000 – 100,000)
∆NPV/∆S = +\$38.476

If sales were to drop by 500 units, then NPV would drop by:

NPV drop = \$35.728(500)
NPV drop = \$19,238.21

You may wonder why we chose 100,000 units. Because it doesn’t matter! Whatever sales
number we use, when we calculate the change in NPV per unit sold, the ratio will be the
same.

b. To find out how sensitive OCF is to a change in variable costs, we will compute the OCF at
a variable cost of \$21.75. Again, the number we choose to use here is irrelevant: We will
get the same ratio of OCF to a one dollar change in variable cost no matter what variable
cost we use. So, using the tax shield approach, the OCF at a variable cost of \$21.75 is:

OCF
new
= [(\$36.50 – 21.75)(95,000) – \$830,000](0.70) + 0.30(\$1,440,000/6)
OCF
new
= \$471,875

So, the change in OCF for a \$1 change in variable costs is:

∆OCF/∆v = (\$405,375– 471,875)/(\$22.75 – 21.75)
∆OCF/∆v = –\$66,500

If variable costs decrease by \$1 then, OCF would increase by \$66,500.

Question 6
The option to abandon reflects our ability to reallocate assets if we find our initial estimates
were too optimistic. The option to expand reflects our ability to increase cash flows from a
project if we find our initial estimates were too pessimistic. Since the option to expand can
increase cash flows and the option to abandon reduces losses, failing to consider these two
options will generally lead us to underestimate a project’s NPV.

Question 7

Question 8

Question 9
Expected NPV
1
= (30%)(\$15m) + (40%)(\$8m) + (30%)(\$0m) = \$7.7m
ExpcctcJ NPI
0
=
\$7.7m
1.1u
= \$7million

Question 10

Question 11
Calculate the NPV and the Equivalent Annual Annuity (EAA) of each bus. Choose the bus
with the lowest costs.
The timeline of the investment opportunity is:
0 1 2 3 4 5 6 7

Old
Reliable
–200 –4 –4 –4 –4 –4 –4 –4
Short &
Sweet
–100 –2 –2 –2 –2

Old Reliable
7
4 1
NPV 200 1
0.11 (1 0.11)
218.85
  −
= − + −
 
+
 
= −

Old Reliable
7
Old Reliable
EAA 1
218.85 1
0.11 (1 0.11)
EAA 46.44
 
− = −
 
+
 
= −

Short and Sweet
4
2 1
NPV 100 1
0.11 (1 0.11)
106.20
  −
= − + −
 
+
 
= −

Short and Sweet
4
Short and Sweet
EAA 1
106.20 1
0.11 (1 0.11)
EAA 34.23
 
− = −
 
+
 
= −

The annual cost of the Short and Sweet bus is less, so they should buy this bus.

Question 12
We need to evaluate the free cash flows associated with each alternative. Note that we only
need to include the components of free cash flows that vary across each alternative. For
example, since NWC is the same for each alternative, we can ignore it.

The spreadsheet below calculates the relevant FCF from each alternative. Note that each
alternative has a negative NPV—this represents the PV of the costs of each alternative. We
should choose the one with the highest NPV (lowest cost), which in this case is purchasing
the existing machine.
0 1 - 7 … 8 - 10
Rent Machine
1 Rent (50,000) (50,000)
2 FCF (rent) (35,000) (35,000)
3 NPV at 8% (234,853)
Purchase Current Machine
4 Maintenance (20,000) (20,000)
5 Depreciation 21,429 —
6 Capital Expenditures (150,000)
7 FCF (purchase current) (150,000) (7,571) (14,000)
8 NPV at 8% (210,469)