Risk Analysis and Project Evaluation: A B C A B Annual Outcome Probability Sales Prob Sales

Chapter 13
Risk Analysis and Project Evaluation
13-1. Petreno Pharmaceuticals Company thinks that there are two possible outcomes for its new facial
care product: Either it will be very successful or customers will not appreciate its “unique appeal.”
The successful outcome has a 60% chance of occurring. It comes with higher revenue of $8
million. The less successful outcome has a 40% change of occurring. This outcome yields total
revenue of $1 million.
Thus, Petreno’s revenue will be either $1 million or $8 million. The expected value summarizes
these two outcomes by weighting each by its probability of occurring:
expected revenue  [(revenue if highly successful)  (probability of success)] 

[(revenue if less successful)  (probability of success)]
 [($8 million)  (50%)]  [($1 million)  (50%)]
 $5,200,000.
We can visualize the calculations using the spreadsheet below:
A B C = A*B
annual
outcome probability sales prob*sales
extremely successful 60% $8,000,000 $4,800,000
not as accepted 40% $1,000,000 $400,000
expected value = $5,200,000
13-2. Koch Transportation estimates that LH Transport’s cash flow next year
will be $50,000, $150,000, or $250,000, with probabilities of 20%, 60% and 20%, respectively.
a. To find the expected value, we will weigh each of the possible outcomes by its associated
probability, then add the products. We show this calculation using the spreadsheet below:
A B C = A*B
state of economy probability cash flow prob*sales
recession 20% ($50,000) ($10,000)
normal 60% $150,000 $90,000
expansion 20% $250,000 $50,000
expected value = $130,000
Thus, the expected cash flow is $130,000. While this lies between the minimum of $50,000
and the maximum of $250,000, it does not equal the simple average of the three outcomes
because the probabilities associated with each state of the economy are not equal.
335
Copyright © 2018 Pearson Education, Inc.
336 Titman/Keown/Martin  Financial Management, Thirteenth Edition
b. If we were to increase the probability of recession to 30% while reducing the probability of
expansion to 10%, the expected value would decrease, as the spreadsheet below shows:
A B C = A*B
recession 30% ($50,000) ($15,000)
normal 60% $150,000 $90,000
expansion 10% $250,000 $25,000
Now the expected value is even lower (even closer to the payoff of the recession state).
c If we are told that the project must average $100,000 per year in order to have a positive NPV,
then our expected value of $130,000 gives us only a moderate cushion. As we saw in the second
scenario above, shifting the recession/expansion probabilities by ten percentage points in the
wrong direction (that is, toward recession, at the expense of the upside expansion scenario)
means that our project would just break even. In order for us to go ahead, we’d want to know
how confident we are in our original 20% probability for recession.
We can demonstrate why a 30% probability of recession is the break-even probability for a
positive NPV project. If we leave the probability of a normal state of the economy at 60%
probability, we can determine the highest possible probability for recession that would be
consistent with a positive NPV. The equation below allows us to solve for the probability (which
turns out to be 30%); the chart and graph below illustrate the result. Thus, if the probability of a
recession (probrec) is greater than 30%, the project will have a negative expected NPV.
$100,000  [(60%)  ($150,000)]  [(probrec)  ($50,000)]  [(100%−60%  probrec)  ($250,000)]
$10,000  $100,000 [probrec  ($50,000  $250,000)]
−$90,000 probrec  ($300,000)
probrec  30%
13-3. a. Rao Roofing is interested in Simpkins Storage Company. Given Rao Roofing’s estimates of
the three states of the economy, the expected value of Simpkins’ cash flow is as follows:
A B C = A*B
recession 25% ($50,000) ($12,500)
normal 55% $150,000 $82,500
expansion 20% $250,000 $50,000
b. Mitchell Storage Company is also is interested in Simpkins Storage Company. Mitchell

Storage Company’s estimates of Simpkins’ cash flows are the same as Rao Roofing’s
estimates for each of the three states of the economy. However, Mitchell Storage has a higher
probability for an expansion (40%, versus Rao Roofing’s 20%), a slightly lower probability for a
normal economy (50% versus 55%), and a lower probability for recession (10% versus 25%).
Simpkins will therefore have a higher expected cash flow with Mitchell Storage Company’s
estimated probabilities as shown below:
A B C = A *B
State of the economy Probability RevenueProb x Cash Flow
recession 10% -$50,000.00 -$5,000.00
normal 50% $150,000.00 $75,000.00
expansion 40% $250,000.00 $100,000.00
Expected Cash Flow $170,000.00
c. If Mitchell Storage has the same discount rate and other inputs as Rao Roofing, an expected
annual cash flow of $170,000 implies that the purchase of Simpkins Storage is a positive NPV

Solutions to End-of-Chapter Problems—Chapter 13 337
project for Mitchell Storage. Mitchell Storage would be more willing to bid aggressively than
would Rao Roofing since Mitchell sees an extra $50,000/year ($170,000 expected cash flow for
Mitchell less the $120,000expected cash flow for Rao Roofing) from the acquisition. Mitchell
is therefore more likely to acquire Simpkins Storage than is Rao Roofing. (Of course, if
Mitchell’s optimism is misplaced, they are also more likely to overpay for Simpkinsthan is
Rao Roofing.)
13-4. To determine the expected revenue for Floating Homes, we need to calculate the following:
expected revenue  [(total revenue if recession)  (probability of recession)] 

[(total revenue if level economy)  (probability of level economy)] 
[(total revenue if strong economy)  (probability of strong economy)].
We were given the probabilities of the various scenarios: 50% for the level case; 25% each for the
extremes. Thus the only thing we need to do is find the revenues for each of the scenarios.
Since the firm sells three kinds of boats, its total revenue in any scenario will be the sum of the
revenues from each of the three kinds (high-priced, medium-priced, and low-priced). These category
revenues are simply the number of units sold times 3
the price per unit. Thus, for each scenario, we
first find the total revenue for each scenario as  (price/unit i ) * (# of unitsi ), where i indexes the
i1
three boat categories. We then can plug those total revenue figures into the equation above; after
multiplying each scenario’s total revenue figure by the probability of the associated scenario, we
sum the products, and voilà! We have our answer.
The spreadsheet below illustrates this process.
scenario I scenario II scenario III

(recession) (level economy) (strong economy) notes
high-priced boats
unit sales 50 400 1,000 A
average price per unit $80,000 $90,000 $95,000 B
category revenue $4,000,000 $36,000,000 $95,000,000 C = A*B
medium-priced boats
unit sales 100 800 3,000 D
average price per unit $60,000 $70,000 $80,000 E
category revenue $6,000,000 $56,000,000 $240,000,000 F = D*E
low-priced boats
unit sales 200 1,500 5,000 G
average price per unit $50,000 $50,000 $50,000 H
category revenue $10,000,000 $75,000,000 $250,000,000 I = G*H
TOTAL REVENUE $20,000,000 $167,000,000 $585,000,000 J=C+F+I

probability 25% 50% 25% K (given)
TR*(probability) $5,000,000 $83,500,000 $146,250,000 L = J*K
sum
EXPECTED REVENUE $234,750,000 sum of L

13-5. To find the expected NPV for Physicians’ Bone and Joint (PB&J) Clinic’s machine, we would
compute the following:
expected NPV  [(NPV if high demand)  (probability of high demand)] 
[(NPV if medium demand)  (probability of medium demand)] 
[(NPV if low demand)  (probability of low demand)].
a. The spreadsheet below illustrates the calculations:
A B C = A*B
demand probability NPV prob*NPV

Low 15% ($300,000) ($45,000)
Medium 60% $200,000 $120,000
High 25% $400,000 $100,000
expected NPV = $175,000
Thus we expect that the NPV will be $175,000. This is the most likely single estimate of
Physicians’ Bone and Joint Clinic’s MRI project’s NPV. (The NPV has a probability distribution
with three possible outcomes. The expected NPV is the “center of gravity” for this probability
distribution.) Given the positive expectation for the project’s NPV, this project looks like a
good opportunity.
b. We can assess our estimate further by determining the highest low-demand probability that is
consistent with an acceptable project. The equation below calculates this probability—the low-
demand probability (problow) that leaves NPV at $0:
$0  [(60%)  ($200,000)]  [(problow)  ($300,000)] 
[(100% − 60%  problow)  ($400,000)]
= $120,000 + [(problow)  ($300,000)] $160,000 – [(problow)  ($400,000)]
$280,000  problow  ($700,000)
problow  $280,000/$700,000  40%.
Thus if we increase the probability of the low demand state to 40% we get an NPV of $0. (It
had to be an increase—since at 15%probability of low demand, we had a higher NPV.)
13-6. To examine Family Security’s new product line using sensitivity analysis, we can follow the
format illustrated in Checkpoint 13.2. We will start by using the expected values, then compare
that result to both the best case and worst case scenarios.
To find the NPV under the expected case, we first must find Family Security’s free cash flow.
This project is relatively simple, because it involves no working capital increment or salvage
value. Thus our free cash flow (FCF) values from t  1 through t  10 (the last year of the 10-year
project’s life) will all be the same. We can find them as follows:
FCF  NOPAT + depreciation

 [revenue – variable costs  depreciation  cash fixed costs  taxes]  depreciation
 {[(price/unit)*(# units sold)]  [(VC/unit)*(# units sold)]  depr  cash fixed costs  taxes}  depr
$1,000,000  $0
 {[($125)*(10,000)]  [($75)*(10,000)]  depreciation  $250,000}  taxes  ( 10
),
NOI annual depreciation
NOPAT

where “taxes” will equal the tax due on the net operating income (NOI) (which is shown in curved
brackets), and the last term is the annual depreciation on a project that costs $1 million, has a $0
salvage value, and is being depreciated on a straight-line basis for 10 years.
Since we can find the net operating profit after tax, NOPAT, as [NOI  taxes]  [NOI  (1  T)],
we have:
FCF  {[($125)  (10,000)]  [($75)  (10,000)]  $100,000  $250,000}  (1  0.34)  $100,000
  [$150,000  (0.66)]  $100,000
 $199,000.
We can now find NPV for this case as:
$199,000 $199,000 $199,000
NPV  $1,000,000    ...
(1.10)1
(1.10) 2
(1.10)10
10
$199,000
 $1,000,000  
t 1 (1.10)
t
 $1,000,000  PV(10%, 10, 199000, 0) (where PV is Excel’s function)

 $222,769 > $0  ACCEPT.
Now we will repeat these calculations using two alternative scenarios: the best case (where unit
sales and price rise by 10% each, while fixed costs and variable costs fall by 10% each) and the
worst case (where units and price fall by 10%, while FC and VC rise by 10%). The results are
shown in the table below (where the grey shading in the top panel, which presents the “givens,”
highlights the variables that change under each scenario):
10% 10%
best worst
expected case case
unit price $125 $137.50 $112.50
variable costs $75 $67.50 $82.50
fixed costs (per year) $250,000 $225,000 $275,000
expected sales per year (units) 10,000 11,000 9,000
initial required outlay $1,000,000 $1,000,000 $1,000,000
WC increment required $0 $0 $0
project life (years) 10 10 10
depreciation method straight line straight line straight line
estimated salvage value $0 $0 $0
required rate of return 10% 10% 10%
marginal tax rate 34% 34% 34%
best worst
expected case case
revenue $1,250,000 $1,512,500 $1,012,500
less: variable costs ($750,000) ($742,500) ($742,500)
less: depreciation expense ($100,000) ($100,000) ($100,000)
less: cash fixed costs ($250,000) ($225,000) ($275,000)
net operating income $150,000 $445,000 ($105,000)
less: taxes ($51,000) ($151,300) $35,700
NOPAT $99,000 $293,700 ($69,300)
plus: depreciation expense $100,000 $100,000 $100,000
less: capex $0 $0 $0
less: change in WC $0 $0 $0
free cash flow (FCF) $199,000 $393,700 $30,700
NPV $222,769 $1,419,116 ($811,362)

Not surprisingly, NPVbest-case > NPVexpected > NPVworst-case. However, since NPVworst-case < $0, so that
the project is unacceptable under these assumptions, the firm should do some careful analysis of
its cost and sales estimates.
13-7. We can find the NPV for Blindfold Technologies, Inc.’s hand scanner project as follows. Starting
with the expected values for costs and sales, we find the firm’s free cash flow for each of the 5
years of the project’s life. As we did in Problem 13-6, we find the cash flows for years 1 through 4
as follows:
FCF  NOPAT  depreciation
 [revenue  variable costs – depreciation - cash fixed costs – taxes]  depreciation
 {[(price/unit)*(# units sold)]  [(VC/unit)*(# units sold)]  depr.  cash fixed costs  taxes}  depr
$10,000,000  $0
 {[($100)*(100,000)]  [($22.50)*(100,000)]  depr.  $1,250,000}  taxes  ( 5
),
NOI annual depreciation
NOPAT
where “taxes” will equal the tax due on the net operating income (NOI) (which is shown in square
brackets), and the last term is the annual depreciation on a project that costs $10 million, has a $0
salvage value, and is being depreciated on a straight-line basis for 5 years.
Since we can find the net operating profit after tax, NOPAT, as [NOI  taxes]  [NOI*(1-T)], we
have:
FCF  {[($100)  (100,000)]  [($22.50)  (100,000)]  $2,000,000  $1,250,000}  (1  0.20) +

$2,000,000
  [$4,500,000  (0.80) + $2,000,000
 $5,600,000.
a. For t  0, the FCF is simply the $10 million cost of the machine, plus the $450,000 working
capital outlay, for a total of −$10,450,000. For t  5, the last year of the project, the FCF is the
$5,600,000 as for the first 4 years, plus $450,000 for WC recovery. Thus, we can find NPV as:
$5,600,000 $5,600,000 $5,600,000 $5,600,000 $6,050,000

NPV  $10, 450,000     
(1.10)1 (1.10)2 (1.10)3 (1.10)4 (1.10)5
$5,600,000 6,050,000
 $10, 450,000   
(1.10)t (1.10)5
 NPV(0.10, 5600000, 5600000, 5600000, 5600000, 6050000)  10450000

(where NPV is Excel’s function)
 $11,057,821 ACCEPT

The spreadsheet below illustrates these calculations year by year:

expected
unit price $100
variable costs $22.50
fixed costs (per year) $1,250,000
expected sales per year (units) 100,000
initial required outlay $10,000,000
project life (years) 5
depreciation method straight line
estimated salvage value $0
working capital increment required $450,000
required rate of return 10%
marginal tax rate 20%
t=0 t=1 t=2 t=3 t=4 t=5

revenue $10,000,000 $10,000,000 $10,000,000 $10,000,000 $10,000,000
less: variable costs ($2,250,000) ($2,250,000) ($2,250,000) ($2,250,000) ($2,250,000)
less: depreciation expense ($2,000,000) ($2,000,000) ($2,000,000) ($2,000,000) ($2,000,000)
less: cash fixed costs ($1,250,000) ($1,250,000) ($1,250,000) ($1,250,000) ($1,250,000)
net operating income $4,500,000 $4,500,000 $4,500,000 $4,500,000 $4,500,000
less: taxes ($900,000) ($900,000) ($900,000) ($900,000) ($900,000)
NOPAT $3,600,000 $3,600,000 $3,600,000 $3,600,000 $3,600,000
plus: depreciation expense $2,000,000 $2,000,000 $2,000,000 $2,000,000 $2,000,000
less: capex ($10,000,000) $0 $0 $0 $0 $0
less: change in WC ($450,000) $0 $0 $0 $0 $450,000
free cash flow (FCF) ($10,450,000) $5,600,000 $5,600,000 $5,600,000 $5,600,000 $6,050,000
NPV = $11,057,821
b. If we were to decrease the number of units sold by 10% or 10,000 units, we would have the
following result (where the grey highlights the changed values):
unit price $100
t=0 t=1 t=2 t=3 t=4 t=5

revenue $9,000,000 $9,000,000 $9,000,000 $9,000,000 $9,000,000
less: taxes ($745,000) ($745,000) ($745,000) ($745,000) ($745,000)
NOPAT $2,980,000 $2,980,000 $2,980,000 $2,980,000 $2,980,000
less: capex ($10,000,000) $0 $0 $0 $0 $0
less: change in WC ($450,000) $0 $0 $0 $0 $450,000
NPV = $8,707,533 LOWER
Not surprisingly, lower unit sales means a lower project NPV. Revenue, variable costs, NOI,
taxes, NOPAT, and FCF all fall. NPV is 21.25% lower under this scenario.

c. If we were to decrease the variable costs per unit by 10% (from $22.50 to $20.25), we would
have the following result (where the grey highlights the changed values):
unit price $100
fixed costs (per year) $1,250,000.00
t=0 t=1 t=2 t=3 t=4 t=5

revenue $10,000,000 $10,000,000 $10,000,000 $10,000,000 $10,000,000
less: taxes ($945,000) ($945,000) ($945,000) ($945,000) ($945,000)
NOPAT $3,780,000 $3,780,000 $3,780,000 $3,780,000 $3,780,000
less: capex ($10,000,000) $0 $0 $0 $0 $0
less: change in WC ($450,000) $0 $0 $0 $0 $450,000
NPV = $11,740,162 HIGHER
In this case, NPV is 6.2% higher than under the original scenario. Lowering variable costs per
unit, while keeping price constant, means a higher gross profit per year, which translates into a
higher NPV for the project overall.
d. On the other hand, when variable cost/unit RISES by 10%, NPV falls by 6.2%:
unit price $100
t=0 t=1 t=2 t=3 t=4 t=5

revenue $10,000,000 $10,000,000 $10,000,000 $10,000,000 $10,000,000
less: taxes ($855,000) ($855,000) ($855,000) ($855,000) ($855,000)
NOPAT $3,420,000 $3,420,000 $3,420,000 $3,420,000 $3,420,000
less: capex ($10,000,000) $0 $0 $0 $0 $0
less: change in WC ($450,000) $0 $0 $0 $0 $450,000
NPV = $10,375,479 LOWER

e. If we increase fixed cost by 10% to $1,375,000, we have:
unit price $100

t=0 t=1 t=2 t=3 t=4 t=5

revenue $10,000,000 $10,000,000 $10,000,000 $10,000,000 $10,000,000
less: taxes ($875,000) ($875,000) ($875,000) ($875,000) ($875,000)
NOPAT $3,500,000 $3,500,000 $3,500,000 $3,500,000 $3,500,000
less: capex ($10,000,000) $0 $0 $0 $0 $0
less: change in WC ($450,000) $0 $0 $0 $0 $450,000
NPV = $10,678,742 LOWER
Again, NPV falls in this case, relative to the initial scenario, by 3.4%. Thus, the NPV for this
project is only about half as sensitive to a change in fixed costs as it is to a change in variable
costs.
We can summarize our work from parts (a) through (e) as follows:
% change
part change NPV in NPV
(a) none (initial scenario) $11,057,821 0.00%
(b) decrease units sold by 10% $8,707,533 -21.25%
(c) decrease VC/unit by 10% $11,740,162 6.17%
(d) increase VC/unit by 10% $10,375,479 -6.17%
(e) increase FC by 10% $10,678,742 -3.43%
We can see from this summary that the project’s NPV is most highly sensitive to the number
of units sold. Blindfold Technologies, Inc. should pay particular attention to careful estimation
of the probability distribution of unit sales.

f. Now, let’s consider comprehensive scenarios.
Base Case
Solution
Revenues $10,000,000.00
Variable cost $2,250,000.00
Fixed Expenses $1,000,000.00
Gross margin $6,750,000.00
Depreciation $2,000,000.00
Net operating income $4,750,000.00
Income tax expense $950,000.00
Net income $3,800,000.00
Cash flow $5,800,000.00
NPV $11,815,977.86
Worst Case
Solution
Revenues $6,300,000.00
Fixed Expenses $1,200,000.00
Income tax expense $270,000.00
Net income $1,080,000.00
Cash flow $3,080,000.00
NPV $1,505,037.85
We’ll start with the worst-case scenario, shown above. This involves lower units sales, lower
price per unit, and higher variable and fixed costs. Having so many things go wrong at once
has a devastating effect on NPV: it falls by 87% from the initial scenario. However, it is still
positive! Thus, this project looks like a winner for Blindfold Technologies, Inc.: even with a
10% lower price, 30% lower unit sales, 10% higher variable costs, and 20% higher fixed costs,
this project still returns more than its cost of capital.

Now, let’s try the best-case scenario:
Best Case
Solution
Revenues $15,600,000.00
Fixed Expenses $900,000.00
Income tax expense $2,072,000.00
Net income $8,288,000.00
Cash flow $10,288,000.00
NPV $28,829,028.88
In this case, we have increased unit sales by 30%, increase price per unit by 20%, decreased
variable cost and fixed costs by 10%. Not surprisingly, the NPV is higher than in the initial
case. In fact, it is 144% higher!
13-8. We are given the following information about Marvel Manufacturing Company’s proposed robotic
production facility:
unit price $1,000

variable costs $600
fixed costs (per year) $80,000
initial required outlay $600,000
depreciation expense per year $100,000
a. Note that fixed costs of $80,000 are cash fixed costs). To find the accounting break-even level
for this project, we use equation 13-2:
F
Qacctg BE  ,
P V
where F is the total fixed cost (which is cash fixed costs plus depreciation), V is the variable
costs per unit, and P is the price per unit, (P-V) in the denominator is therefore the
contribution margin per unit. Thus, for Marvel’s project, we have:
$80,000  $100,000
Q acctgBE   450 units
$1,000  $600
If each unit contributed ($1000  $600)  $400 toward fixed costs, then Marvel only needs to
sell 450 units to cover fixed costs (including depreciation).

Of course, depreciation is a non-cash charge. If we wanted to focus only on the cash fixed costs
that Marvel incurs, we’d delete depreciation from the numerator of the above ratio, giving us
the cash break-even value:
$80,000
Q cash BE   200 units.
$1,000  $600
When we ignore depreciation, it takes many fewer units—only 200—to break even.
b. If the firm plans to sell 2000 units, operating profit will be $620,000 based on sales of
$2,000,000  1,200,000 (vc)  100,000 (depreciation)  80,000 (cash fixed costs).
c. Cash flow at 2000 units sold will be positive as well. Assuming a 34% tax rate, and $620,000
operating profit, NOPAT will be $409,200 ($620,000  0.66) and FCF will be $509,200
(NOPAT plus $100,000 depreciation added back).
13-9. We are given various information for four projects and asked to use what we’re given to calculate
a missing value. All of the values can be calculated using equation 13-2 for accounting break-even:
F
a. QacctgBE 
P V
FCFC  D
QacctgBE 
P V
where F is total fixed costs, CFC is the cash fixed cost, D is depreciation, V is the variable
costs per unit, and P is the price per unit. Rearranging this equation to solve for P, V, F, CFC,
and D, we find the following:
A P V CFC D
A = (CFC + D)/(P-V) P = [(CFC + D)/A] + V V = P - [(CFC + D)/A] CFC = [(P-V)*A] - D D = (P - V)*A - CFC
accounting break
even point price variable cost cash
project (units) per unit per unit fixed costs depreciation
A 6,250 $75 $55 $100,000 $25,000
B 750 $1,000 $200 $500,000 $100,000
C 2,000 $20 $15 $5,000 $5,000
D 2,000 $20 $5 $15,000 $15,000
b. Projects C and D have the same accounting break-even level of 2000 units. However, if
we had sales above that level, we would prefer project D, as shown in the graph below. Project C
as much higher variable costs than D, so that we get only ($20  $15)  $5 gross profit per unit.
However, with project D, we pay only $5 in variable cost per unit, so that each $20 sale gives us
an extra $15.

$25,000
$15,000
NOI $5,000
project C
project D
500 1000 1500 2000 2500 3000 3500 4000
($5,000)
($15,000)
($25,000)
number of units sold
c. If we calculate the cash break-even for each project, we find the number of units that the firm
must sell to cover the cash fixed costs. This will clearly be a lower number of units than the
accounting break-even (since the latter requires that the firm also cover depreciation). As shown
below, the cash break-evens for the four projects are 5000, 625, 1000, and 1000, respectively.
A C P V F D
A = (CFC + D)/(P - V) C = CFC/(P - V) % = (A-C)/A % = D/(CFC + D) P = [(CFC + D)/A] + V V = P - [(CFC + D)/A] CFC = [(P - V)*A] - D D = [(P - V)*A] - CFC
accounting break cash break difference depreciation

even point even point in break evens as % of price variable cost
project (units) (units) (% of accounting) total fixed costs per unit per unit fixed costs depreciation
A 6,250 5,000 20.00% 20.00% $75 $55 $100,000 $25,000
B 750 625 16.67% 16.67% $1,000 $200 $500,000 $100,000
C 2,000 1,000 50.00% 50.00% $20 $15 $5,000 $5,000
D 2,000 1,000 50.00% 50.00% $20 $5 $15,000 $15,000
What does the difference between the two break-even measures imply? As shown above, the
difference between the two measures reflects the relative importance of depreciation in the
firm’s fixed-cost structure. When depreciation makes up half of the firm’s total fixed costs (as
it does for projects C and D), the cash break-even will be only half of the accounting break-
even. However, when depreciation is only 20% of total fixed costs (as with project A), the cash
break-even is only 20% lower than the accounting break-even.
13-10. We are given the following information about Mayborn Enterprises’ proposed T-shirt business:
unit price $16

variable costs/unit $10
fixed cash costs (per year) $10,000
depreciation expense per year $4,000
a. Using equation 13-2 for accounting break-even, we find:

Qacctg BE = (CFC + D)/(P – V) = ($10,000 + $4,000)/($16 - $10) = 2,333 units.

Thus, Mayborn must sell 2,333 units in order to cover both its fixed cash costs and its
depreciation expense. If it were to ignore depreciation, which doesn’t actually consume cash,
it would use equation 13-2a to find cash break-even:
Qcash BE = (F – D)/(P – V) = $10,000/($16 - $10) = 1667 units.
Cash break-even is smaller, since it omits the [$4,000/($16 - $10)] = 667 units needed to cover
depreciation.
b. Bill Mayborn is right to question the concept of accounting break-even. Since depreciation is
not a cash flow, the firm does not really need to sell the extra units to cover depreciation in the
short run. However, machines need to be replaced eventually. Depreciation expenses may
approximate the capital investment that firms need to make to sustain their businesses; firms
that only over their cash costs may be unsustainable. Of course, neither break-even method
allows Mayborn to cover the costs of its capital; its true break-even is much larger than either
of these two methods suggest.
13-11. We know the following about Niece Equipment Rental’s crane proposal:
unit price (per hour) $500

variable costs (per hour) $200
storage/maintenance (per month) $1,000
depreciation expense (per year) $50,000
a. To determine the accounting and cash break-even points, we use equations 13-2 and 13-2a,
respectively:
Q acctg BE = (CFC + D)/(P – V) = 206.67 hours
Where CFC is cash fixed cost. Thus, Niece must rent out the crane for almost 207 hours in
order to cover both its fixed cash costs and its depreciation expense. To find cash break-even,
we omit the depreciation, finding:
b. Q acctg BE = (CFC )/(P – V) = 40 hours
Where F only includes all fixed cost including depreciation expense. The cash break-even is
so much smaller! The depreciation charge for the crane is so much larger than its annual storage
costs (which are [$1000/month]  12 months  $12,000) that it only takes 40 hours’ worth of
rentals per year to cover the storage costs, but (207  40)  167 hours to cover depreciation.
$120,000
$100,000
Niece's crane
project has large
$80,000 fixed costs.
dollars
$60,000 total revenue

total costs (w/depreciation)
total costs (w/o depreciation)
$40,000
$20,000
cash break accounting

even break even
$0
0 50 100 150 200 250
number of hours rented

c. We have two break-even points because we want to know both how many units we need to
cover short-run cash operating costs and longer-term, all-in, costs. If we can’t even meet our
cash operating costs (by selling the cash break-even number of units), then the project is a
clear loser. But depreciation expenses—standing in for capital expenditures—must eventually
be covered; selling fewer units than accounting break-even suggests the project is
unsustainable. Of course, neither measure accounts for the cost of capital, so both are too low
to cover all economic costs.
13-12. Baker-Huggy, Inc. currently has fixed costs (F) of $100,000 and net operating income (NOI) of
$30,000. Using equation 13-4, we can calculate Baker-Huggy’s degree of operating leverage
(DOL) as:
DOL = 1 + F/NOI = $100,000/$30,000 = 4.333
Now since we can also define DOL using equation 13-3:
% change in NOI
DOL  ,
% change in sales
we know that:
% change in NOI  (DOL)  (% change in sales).

Thus if sales increase by 20%, NOI will rise by 86.7%:
% change in NOI  (4.333)  (20%)  86.67%,

while if sales fall by 20%, NOI will fall by 86.67%:
% change in NOI  (4.333)  (20%) −.

Thus, the degree of operating leverage magnifies the percentage change in sales. This happens
because Baker-Huggy has some fixed costs in its structure. These fixed costs provide a “wedge”
between sales performance and NOI, since these costs do not change with sales. (If Baker-Huggy
had no fixed costs, NOI would change at the same rate as sales.)
13-13. If B & L, Inc. has a sales increase of 10%, it believes that its NOI would increase by 60%. We can
use equation 13-3 to infer what these figures tell us about the firm’s degree of operating leverage
(DOL):
% change in NOI 60%
DOL    6.
%change in sales 10%
Thus, B & Ls fixed cost/variable cost structure at this point implies that the firm can magnify the
percentage increase in sales six times. Now, using equation 13-4, we can see what this implies
about the level of the firm’s fixed costs:
DOL = 1 + F/NOI.
6 = 1 + F/$15,000,000 → F = $75,000,000
The firm has $75 million in fixed costs. Having such a substantial fixed component to its cost
structure allows the firm to magnify its change in sales (both up and down—things won’t look so
rosy when sales fall).
13-14. Chapter 13 discusses three broad types of real options: delay options, expansion options, and
abandonment options. CGC Corporation’s casino project has each of these types.

OPTION TO DELAY
CGC could delay any of its casino building projects. For example, it could delay the major renovation of
its current Biloxi casino, perhaps by doing the minor renovation now and waiting to see how its Biloxi
competitors rebuild. This option does not seem too valuable, however; the firm has substantial first-mover
advantages in Biloxi, since its competition was wiped out completely. It could delay its expansion into
Gulf Shores. It could delay any move out of the hurricane area.
These delay options are clearly not the most valuable options inherent to the situation.
OPTION TO EXPAND
This is the most salient of CGC’s options. The option to do a major renovation of its Biloxi casino is the
most important of these options. It is most valuable now; the longer CGC waits (using its option to delay),
the less valuable this expansion option appears to become (but one never knows—the firm may learn
something by waiting that may enhance the value of this expansion option). The firm also has the option to
expand into new markets: Gulf Shores and/or areas outside the hurricane belt.
OPTION TO ABANDON
CGC has the option to abandon the Biloxi casino in favor of one of the other locations. Or it could
abandon the business completely, and move into something else.
There are many options available to CGC, and each choice it makes opens up new options in the future.
The tree below shows just a few of these options (it is not meant to be exhaustive!). It is not possible to
identify all options, and some of the options that one can identify are not valuable (because they would
never be chosen—they would be “pruned” from the tree in favor of a more valuable choice). However, it
is fruitful for a manager to consider these options, since it forces her to consider the broader ramifications
of her immediate decision.
t=0 t=1 t=2
abandon: leave Biloxi

reduce scope of Biloxi renovation
abandon Gulf Shores
expand: move into Gulf Shores
expand: increase size of Gulf Shores casino
expand: major renovation in Biloxi expand: move into nonhurricane area
abandon: leave Biloxi
delay: wait to decide
13-15. a. The restaurant project you’re considering looks like this:
50% restaurant well received expand: build 10 more restaurants

(each restaurant generates $800,000/year forever)
50% restaurant not well received do not expand

(restaurant generates $200,000/year forever)
The initial restaurant may be built even though its expected cash flow is negative because there is value
in the restaurant’s option to expand. If the restaurant is well-received, 10 more restaurants will be built,
increasing the cash flow beyond that generated by the original restaurant. The additional cash flow
from the 10 other restaurants turns NPV positive.

b. If the restaurant is not favorably received, it will provide a cash flow of $200,000 per year
$200,000
forever. At a discount rate of 10%, the PV of this perpetuity is ( 0.10 )  $2 million. The NPV
in this case is therefore ($2 million  $6 million)  $4 million. On the other hand, if the
$800,000
restaurant is favorably received, its PV will be ( 0.10 )  $8 million,1 with an NPV of ($8
million  $6 million)  $2 million. This is per restaurant. However, you will expand in this
case, leaving you with a total of 11 restaurants (the original restaurant, plus 10 more).
Now we can find your expected NPV as:
expected NPV  [(50% chance of favorable reception)  ($2 million NPV per restaurant) 
(11 restaurants)]  [(50% chance of unfavorable reception) 
($4 million NPV per restaurant)  (1 restaurant)]
expected NPV  $9 million
When you consider the option to expand, the NPV is positive. Thus, it is probably worth your
while to go ahead, now that you can see the potential for the restaurant.
13-16. The nickel-metal hydride battery project that Go-Power Batteries is considering costs $50
millionM and offers expected future cash flows whose present value is $40 million. Thus the
project’s NPV for Go-Power is $10 million. However, the firm can also sell the technology to
Toyota for $10M. Would it ever consider going ahead with the plant?
We saw in Checkpoint 13.5 and Problem 13-15 that we may choose to go ahead if we consider
expansion options. For example, let’s assume that Go-Power has a 10% cost of capital. If the
demand for hybrid cars remains small, the battery factory will generate $2 million/year forever, so
that it has a PV of future cash flows of ( $20.10M )  $20 million. However, if the market expands, the
plant will generate $6 million/year, for a PV of ( $6 M
0.10  $60 million. If each state is equally likely,
)
then the expected cash flows from this project have a value of (50%)  ($20 million)  (50%) 
($60 million)  $40 million, and the overall project has an NPV of ($40 million  $50 million) 
$10 million, as we were told.
However, let’s look at each case separately. In the favorable case, the NPV is ($60 million  $50
million)  $10 million; in the low case, it’s ($20 million  $50 million)  $30 million. (Again,
we can see the $10 million we were given: it is [(50%)  ($10 million)]  [(50%)  ($30
million)]  $10 million.) However, if we were to exercise an option to expand in the high-
demand case, say by building four more plants (for a total of five), we’d have:
expected NPV  [(50% chance of high demand)  ($10 million NPV per plant)  (5 plants)] 
[(50% chance of low demand)  ($30 million NPV per plant)  (1 plant)]
expected NPV  $10 million.
Now, Go-Power is indifferent between going ahead itself and selling to Toyota. Thus, any increase
in the probability of the high state would make the firm prefer to keep the project. (This is only one
way to could get this result. For example, we could also increase the number of plants [the demand
would have to be really high!]. We could also increase the cash flow in the high-demand state.)
50% hybrid car market remains small keep one plant

(plant generates $2M/year forever)
50% hybrid car market expands build 4 more plants

(each plant generates $6M/year forever)
1
Note that we can now verify the $5 million given in the problem; this expected PV of future cash flows is [(50%) 
($2 million)]  [(50%)  ($8 million)]  $5 million.

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Chapter 13

Risk Analysis and Project Evaluation

expected revenue  [(revenue if highly successful)  (probability of success)] 

b. Mitchell Storage Company is also is interested in Simpkins Storage Company. Mitchell

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expected revenue  [(total revenue if recession)  (probability of recession)] 

The spreadsheet below illustrates this process.

scenario I scenario II scenario III

TOTAL REVENUE $20,000,000 $167,000,000 $585,000,000 J=C+F+I

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demand probability NPV prob*NPV

FCF  NOPAT + depreciation

NOI annual depreciation

Copyright © 2018 Pearson Education, Inc.

 $1,000,000  PV(10%, 10, 199000, 0) (where PV is Excel’s function)

NPV $222,769 $1,419,116 ($811,362)

Copyright © 2018 Pearson Education, Inc.

FCF  NOPAT  depreciation

 [revenue  variable costs – depreciation - cash fixed costs – taxes]  depreciation

NOI annual depreciation

FCF  {[($100)  (100,000)]  [($22.50)  (100,000)]  $2,000,000  $1,250,000}  (1  0.20) +

$5,600,000 $5,600,000 $5,600,000 $5,600,000 $6,050,000

 NPV(0.10, 5600000, 5600000, 5600000, 5600000, 6050000)  10450000

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The spreadsheet below illustrates these calculations year by year:

t=0 t=1 t=2 t=3 t=4 t=5

t=0 t=1 t=2 t=3 t=4 t=5

NPV = $8,707,533 LOWER

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t=0 t=1 t=2 t=3 t=4 t=5

NPV = $11,740,162 HIGHER

t=0 t=1 t=2 t=3 t=4 t=5

NPV = $10,375,479 LOWER

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unit price $100

t=0 t=1 t=2 t=3 t=4 t=5

NPV = $10,678,742 LOWER

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f. Now, let’s consider comprehensive scenarios.

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unit price $1,000

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accounting break cash break difference depreciation

unit price $16

a. Using equation 13-2 for accounting break-even, we find:

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unit price (per hour) $500

$60,000 total revenue

cash break accounting

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% change in NOI  (DOL)  (% change in sales).

% change in NOI  (4.333)  (20%)  86.67%,

% change in NOI  (4.333)  (20%) −.

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abandon: leave Biloxi

abandon: leave Biloxi

delay: wait to decide

13-15. a. The restaurant project you’re considering looks like this:

50% restaurant well received expand: build 10 more restaurants

50% restaurant not well received do not expand

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50% hybrid car market remains small keep one plant