Solution 8/13/2015

Chapter: 11 Estimating Cash Flows and Analyzing Risk

Problem: 18

Webmasters.com has developed a powerful new server that would be used for corporations’ Internet activities. It
would cost $10 million at Year 0 to buy the equipment necessary to manufacture the server. The project would
require net working capital at the beginning of each year in an amount equal to 10% of the year's projected sales; for
example, NWC0 = 10%(Sales1). The servers would sell for $24,000 per unit, and Webmasters believes that variable
costs would amount to $17,500 per unit. After Year 1, the sales price and variable costs will increase at the inflation
rate of 3%. The company’s nonvariable costs would be $1 million at Year 1 and would increase with inflation.

The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4
years. Also, the project's returns are expected to be highly correlated with returns on the firm's other assets. The
firm believes it could sell 1,000 units per year.

The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of
the equipment at the end of the project’s 4-year life is $500,000. Webmasters’ federal-plus-state tax rate is 40%. Its
cost of capital is 10% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8
and 1.2. Low-risk projects are evaluated with a WACC of 8%, and high-risk projects at 13%.

a. Develop a spreadsheet model, and use it to find the project’s NPV, IRR, and payback.

Input Data (in thousands of dollars)

Equipment cost $10,000 Key Results:
Net operating working capital/Sales 10% NPV = $0
First year sales (in units) 1,000 IRR = 0.0%
Sales price per unit $24.00 Payback = 0.00
Variable cost per unit (excl. depr.) $17.50
Nonvariable costs (excl. depr.) $1,000
Market value of equipment at Year 4 $500
Tax rate 40%
WACC 10%
Inflation in prices and costs 3.0%
Estimated salvage value at year 4 $500

Intermediate Calculations 0 1 2 3 4
Units sold
Sales price per unit (excl. depr.)
Variable costs per unit (excl. depr.)
Nonvariable costs (excl. depr.)
Sales revenue
Required level of net operating working capital
Basis for depreciation
Annual equipment depr. rate
Annual depreciation expense
Ending Bk Val: Cost – Accum Dep'rn

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Salvage value
Profit (or loss) on salvage
Tax on profit (or loss)
Net cash flow due to salvage
Years
Cash Flow Forecast 0 1 2 3 4
Sales revenue
Variable costs
Nonvariable operating costs
Depreciation (equipment)
Oper. income before taxes (EBIT)
Taxes on operating income (40%)
Net operating profit after taxes
Add back depreciation
Equipment purchases
Cash flow due to change in NOWC
Net cash flow due to salvage
Net Cash Flow (Time line of cash flows)

Key Results: Appraisal of the Proposed Project

Net Present Value (at 10%) =

IRR =
MIRR =
Payback =
Discounted Payback =
Data for Payback Years Years
0 1 2 3 4
Net cash flow
Cumulative CF
Part of year required for payback

Data for Discounted Payback Years Years

0 1 2 3 4
Net cash flow
Discounted cash flow
Cumulative CF
Part of year required for discounted payback

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 1,000
$24.00
$17.50

Page 3
 1,200
$28.80
$14.00

Page 4
 800
$19.20
$21.00

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