Chapter 9: Risk Analysis, Real Options, and Capital Budgeting Questions and Problems: 9.1 A

Chapter 9: Risk Analysis, Real Options, and Capital Budgeting
Questions and Problems:
9.1 a. To calculate the accounting breakeven, we first need to find the depreciation for each year.
The depreciation is:
Depreciation = $724,000 / 8
Depreciation = $90,500 per year
And the accounting breakeven is:
QA = ($850,000 + $90,500) / ($39 – $23)

QA = 58,781 units
b. We will use the tax shield approach to calculate the Operating Cash Flow, OCF. The OCF
is:
OCFbase = [(Price – Variable cost) × Sales units – Fixed cost] × (1 – Tc) + Tc × Depreciation
OCFbase = [($39 – $23) × 75,000 – $850,000] × (0.65) + 0.35 × ($90,500)
OCFbase = $259,175
Now we can calculate the NPV using our base-case projections. There is no salvage value
or NWC, so the NPV is:
8
NPVbase = –$724,000 + $259,175 × Α 15%
NPVbase = $439,001.55
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 80,000 units. The NPV at this sales level
is:
OCFnew = [($39 – $23) × (80,000) – $850,000] × (0.65) + 0.35 × ($90,500)

OCFnew = $311,175
And the NPV is:

8
NPVnew = – $724,000 + $311,175 × Α 15 %
NPVnew = $672,342.27
So, the change in NPV for every unit change in sales is:
NPV/S = ($439,001.55 – $672,342.27) / (75,000 – 80,000)

NPV/S = $46.668
Ross et al, Corporate Finance 8th Canadian Edition Solutions Manual

© 2019 McGraw-Hill Education Ltd.
9-1
9-2
If sales were to drop by 500 units, then NPV would drop by:
NPV drop = $46.668 × (500) = $23,334.07
You may wonder why we chose 80,000 units. 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.
c. To find out how sensitive OCF is to a change in variable costs, we will compute the OCF at
a variable cost of $24. 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 $24 is:
OCFnew = [($39 – $24) × (75,000) – $850,000] × (0.65) + 0.35 × ($90,500)

OCFnew = $210,425
So, the decrease in OCF for a $1 increase in variable costs is:
OCF/v = ($259,175 – $210,425) / ($23 – $24)

OCF/v = –$48,750
If variable costs decrease by $1 then, OCF would increase by $48,750.
9.2 We will use the tax shield approach to calculate the OCF for the best- and worst-case scenarios.
For the best-case scenario, the price and quantity increase by 10 percent, so we will multiply the
base case numbers by 1.1, a 10 percent increase. The variable and fixed costs both decrease by
10 percent, so we will multiply the base case numbers by .9, a 10 percent decrease. Doing so, we
get:
OCFbest = {[($39) × (1.1) – ($23) × (0.9)] × (75,000) × (1.1) – $850,000 × (0.9)} × (0.65)
+ 0.35 × ($90,500)
OCFbest = $724,900.00
The best-case NPV is:

8
NPVbest = –$724,000 + $724,900 × Α 15 %
NPVbest = $2,528,859.36
For the worst-case scenario, the price and quantity decrease by 10 percent, so we will multiply
the base case numbers by .9, a 10 percent decrease. The variable and fixed costs both increase by
10 percent, so we will multiply the base case numbers by 1.1, a 10 percent increase. Doing so,
we get:
OCFworst = {[($39) × (0.9) – ($23) × (1.1)] × (75,000) × (0.9) – $850,000 × (1.1)} × (0.65)
+ 0.35 × ($90,500)
OCFworst = –$146,100
9-3
The worst-case NPV is:
8
NPVworst = –$724,000 – $146,100 × Α 15 %
NPVworst = –$1,379,597.67
9.3 We can use the accounting breakeven equation:
QA = (Fixed cost + Depreciation) / (Price – Variable cost)
to solve for the unknown variable in each case. Doing so, we find:
(1): QA = 95,300 = ($820,000 + Depreciation) / ($41 – $30)

D = $228,300
(2): QA = 143,806 = ($2.75 million + $1.15 million) / (P – $56)

P = $83.12
(3): QA = 7,835 = ($160,000 + $105,000) / ($97 – v)

v = $63.18
9.4 If we purchase the machine today, the NPV is the difference between the present value of the
increased cash flows and the machine cost, so:
10
NPV0 = –$1,800,000 + $340,000 × Α 12%
NPV0 = $121,075.83
We should not necessarily purchase the machine today. We would want to purchase the machine
when the NPV is the highest. So, we need to calculate the NPV each year. The NPV each year
will be the difference between the present value of the increased cash flows and the machine cost.
We must be careful, however. In order to make the correct decision, the NPV for each year must
be taken to a common date. We will discount all of the NPVs to today. Doing so, we get:
9
Year 1: NPV1 = [–$1,670,000 + $340,000 × Α 12 % ] / 1.12
NPV1 = $126,432.97
8
Year 2: NPV2 = [–$1,540,000 + $340,000 × Α 12 % ] / 1.122
NPV2 = $118,779.91
7
Year 3: NPV3 = [–$1,410,000 + $340,000 × Α 12 % ] / 1.123
NPV3 = $100,843.05

9-4
6
Year 4: NPV4 = [–$1,280,000 + $340,000 × Α 12 % ] / 1.124
NPV4 = $74,913.91
5
Year 5: NPV5 = [–$1,150,000 + $340,000 × Α 12 % ] / 1.125
NPV5 = $42,911.04
4
Year 6: NPV6 = [–$1,150,000 + $340,000 × Α 12 % ] / 1.126
NPV6 = –$59,428.45
The company should purchase the machine one year from now when the NPV is the highest.
9.5 We need to calculate the NPV of the two options, go directly to market now, or utilize test
marketing first. The NPV of going directly to market now is:
NPV = CSuccess × (Prob. of Success) + CFailure × (Prob. of Failure)

NPV = $22,000,000 × (0.50) + $9,000,000 × (0.50)
NPV = $15,500,000
Now we can calculate the NPV of test marketing first. Test marketing requires a $1.5 million
cash outlay. Choosing the test marketing option will also delay the launch of the product by one
year. Thus, the expected payoff is delayed by one year and must be discounted back to year 0.
NPV= C0 + {[CSuccess (Prob. of Success)] + [CFailure (Prob. of Failure)]} / (1 + r)t

NPV = –$1,500,000 + {[$22,000,000 × (0.80)] + [$9,000,000 × (0.20)]} / 1.11
NPV = $15,977,477.48
The company should test market first with the product since that option has the highest expected
payoff.
9.6 We need to calculate the NPV of each option, and choose the option with the highest NPV. So,
the NPV of going directly to market is:
NPV = CSuccess (Prob. of Success)

NPV = $1,900,000 × (0.50)
NPV = $950,000
The NPV of the focus group is:
NPV = C0 + CSuccess × (Prob. of Success)

NPV = –$175,000 + $1,900,000 × (0.65)
NPV = $1,060,000
And the NPV of using the consulting firm is:
NPV = C0 + CSuccess × (Prob. of Success)

9-5
NPV = –$390,000 + $1,900,000 × (0.80)
NPV = $1,130,000
The firm should use the consulting firm since that option has the highest NPV.
9.7 The company should analyze both options, and choose the option with the greatest NPV. So, if
the company goes directly to the market, the NPV is:
NPV = CSuccess × (Prob. of Success) + CFailure × (Prob. of Failure)

NPV = $19,000,000 × (0.55) + $6,000,000 × (0.45)
NPV = $13,150,000.00
Customer segment research requires a $1.2 million cash outlay. Choosing the research option
will also delay the launch of the product by one year. Thus, the expected payoff is delayed by
one year and must be discounted back to year 0. So, the NPV of the customer segment research
is:
NPV= C0 + {[CSuccess (Prob. of Success)] + [CFailure (Prob. of Failure)]} / (1 + r)t

NPV = –$1,200,000 + {[$19,000,000 × (0.70)] + [$6,000,000 × (0.30)]} / 1.15
NPV = $11,930,434.78
The company should go directly to the market since it has the larger NPV.
9.8 Using the tax shield approach, the OCF at 90,000 units will be:
OCF = [(Sale price – Variable cost) × Sales units – Fixed cost] × (1 – TC) + TC × (Depreciation)
OCF = [($37 – $23) × (90,000) – $195,000] × (1 – 0.34) + 0.34 × ($480,000 / 4 years)
OCF = $743,700
To find the sensitivity of the operating cash flow to the changes in the quantity sold, we will
calculate the OCF at 91,000 units. The choice of the second level of quantity sold is arbitrary
and irrelevant. No matter what level of units sold we choose, we will still get the same
sensitivity. So, the OCF at this level of sales is:
OCF = [($37 – $23) × (91,000) – $195,000] × (1 – 0.34) + 0.34 − ($480,000 / 4 years)

OCF = $752,940
The sensitivity of the OCF to changes in the quantity sold is:
Sensitivity = OCF/Q = ($743,700 – $752,940) / (90,000 – 91,000)

OCF/Q = $9,240 / 1,000 = $9.24
So, the OCF will increase by $9.24 for every additional unit sold.
9.9 a. The base-case, best-case, and worst-case values are shown below. Remember that in the
best-case, unit sales increase, while costs decrease. In the worst-case, unit sales decrease,
and costs increase.

9-6
Scenario Unit sales Variable cost Fixed costs
Base 450 $15,400 $610,000
Best 495 $13,860 $549,000
Worst 405 $16,940 $671,000
Using the tax shield approach, the OCF and NPV for the base case estimate are:
OCFbase = [($18,000 – $15,400) × (450) – $610,000] × (0.65)

OCFbase = $364,000.
PV of CCA Tax Shield :

CDT c 1+0. 5 k
×
= k +d 1+k
$ 820 ,000×0 . 20×0 . 35 1+(0 .5×0 . 15)
= × =$153,304 . 35
0 . 15+0 .20 1+0. 15
4
NPVbase = – $820,000 + $364,000 Α 15 % + $153,304 .35
NPVbase = $372,516.47
The OCF and NPV for the worst case estimate are:
OCFworst = [($18,000 – $16,940)(405) – $671,000](0.65)

OCFworst = –$157,105

CD T c 1+0.5 k
¿ x
k+d 1+ k
$ 820,000 x 0.20 x 0.35 1+0.5 x 0.15
¿ x =$ 153,304.35
0.15+0.20 1+0.15
4
NPVworst = –$820,000 – $157,105 Α 15 % + $153,304 .35
NPVworst = –$1,115,227.03
And the OCF and NPV for the best case estimate are:
OCFbest = [($18,000 – $13,860)(495) – $549,000](0.65)

OCFbest = $975,195.00

CD T c 1+0.5 k
¿ x
k+d 1+ k
$ 820 ,000×0 . 20×0 . 35 1+(0 .5×0 . 15)

= ∗ =$153,304 . 35
0 . 15+0 .20 1+0. 15
9-7
4
NPVbest = – $820,000 + $975,195 Α 15% + $153,304 .35
NPVbest = $2,117,464.97
b. To calculate the sensitivity of the NPV to changes in fixed costs, we choose another level of
fixed costs. We will use fixed costs of $620,000. The OCF using this level of fixed costs
and the other base case values with the tax shield approach, we get:
OCF = [($18,000 – $15,400)(450) – $620,000](0.65)

OCF = $357,500.00
And the NPV is:

4
NPV = – $820,000 + $357,500 Α 15% + $153,304 .53
NPV = $353,959.29
The sensitivity of NPV to changes in fixed costs is:
NPV/FC = ($372,516.47– $353,959.29) / ( $610,000 – $620,000)

NPV/FC = –$1.86
For every dollar FC increase, NPV falls by $1.86.
c. Convert PVCCATS to an EAC:

4
EACPVCCATS = $153,304.35 / Α 15 % = $53,697.20
Convert the initial investment to an EAC:

4
EAC = $820,000 / Α 15 % = $287,217.59
Financial break-even is:

[$287,217.59 + $610,000 x (1 – 0.35) - $53,697.20)] / [($18,000 - $15,400) x (1 – 0.35)] =
372.79 or 373 units.
9.10The marketing study and the research and development are both sunk costs and should be
ignored. We will calculate the sales and variable costs first. Since we will lose sales of the
expensive clubs and gain sales of the cheap clubs, these must be accounted for as outflows and
inflows, respectively. The total sales for the new project will be:

9-8
Sales
New clubs $875  60,000 = $52,500,000
Exp. clubs $1,100  (–12,000) = -$13,200,000
Cheap clubs $400  15,000 = $6,000,000
$45,300,000
For the variable costs, we must include the units gained or lost from the existing clubs. Note that
the variable costs of the expensive clubs are an inflow. If we are not producing the sets any
more, we will save these variable costs, which is an inflow. So:
Var. costs
New clubs –$430  60,000 = –$25,800,000
Exp. clubs –$620  (–12,000) = $7,440,000
Cheap clubs –$210  15,000 = –$3,150,000
–$21,510,000
The pro forma income statement and OCF calculations will be:
Investment -$29,400,000
WC -$1,400,000 $1,400,000
Sales $45,300,000 $45,300,000 $45,300,000 $45,300,000 $45,300,000 $45,300,000 45,300,000
Variable costs -21,510,000 -21,510,000 -21,510,000 -21,510,000 -21,510,000 -21,510,000 -21,510,000
Fixed costs -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000
CCA at 20% -2,940,000 -5,292,000 -4,233,600 -3,386,880 -2,709,504 -2,167,603 -1,734,083
EBIT 11,550,000 9,198,000 10,256,400 11,103,120 11,780,496 12,322,397 12,755,917
Taxes at 40% 4,620,000 3,679,200 4,102,560 4,441,248 4,712,198 4,928,959 5,102,367
NI 6,930,000 5,518,800 6,153,840 6,661,872 7,068,298 7,393,438 7,653,550
Add CCA 2,940,000 5,292,000 4,233,600 3,386,880 2,709,504 2,167,603 1,734,083
Cash flows 9,870,000 10,810,800 10,387,440 10,048,752 9,777,802 9,561,041 9,387,633
from
operations
Total Cash -$30,800,000 $9,870,000 $10,810,800 $10,387,440 $10,048,752 $9,777,802 $9,561,041 $10,787,633
flows
So, the payback period is:
Payback period = 2 years + $8,719,200 / $10,387,440

Payback period = 2.84 years
The NPV is:
NPV = –$30,800,000 + $9,870,000 / 1.14 + $10,810,800/1.142+ $10,387,440/1.143

+ $10,048,752/1.144 + $9,777,802/1.145 + $9,561,041/1.146 + $10,787,633/1.147
NPV = $12,882,655

9-9
And the IRR is:
NPV= –$30,800,000 + $9,870,000 / (1+IRR) + $10,810,800 / (1+IRR)2

+ $10,387,440 / (1+IRR)3 + $10,048,752 / (1+IRR)4 + $9,777,802 / (1+IRR)5
+ $9,561,041 / (1+IRR)6 + $10,787,633 / (1+IRR)7 = 0
IRR = 26.8%
9.11To calculate the sensitivity of the NPV to changes in the price of the new club, we simply need
to change the price of the new club. We will choose $885, but the choice is irrelevant as the
sensitivity will be the same no matter what price we choose.
We will calculate the sales and variable costs first. Since we will lose sales of the expensive
clubs and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales
for the new project will be:
Sales
New clubs $885  60,000 = $53,100,000
Exp. clubs $1,100  (– 12,000) = -$13,200,000
Cheap clubs $400  15,000 = $6,000,000
$45,900,000
Var. costs
New clubs –$430  60,000 = –$25,800,000
Exp. clubs –$620(–12,000)= $7,440,000
Cheap clubs –$210  15,000 = –$3,150,000
–$21,510,000
The pro forma income statement and OCF will be:
WC -$1,400,000 $1,400,000
Sales $45,900,000 $45,900,000 $45,900,000 $45,900,000 $45,900,000 $45,900,000 45,900,000
Variable -21,510,000 -21,510,000 -21,510,000 -21,510,000 -21,510,000 -21,510,000 -21,510,000
costs
Fixed costs -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000
CCA at -2,940,000 -5,292,000 -4,233,600 -3,386,880 -2,709,504
20% -2,167,603 -1,734,083
EBIT 12,150,000 9,798,000 10,856,400 11,703,120 12,380,496 12,922,397 13,355,917
Taxes at 4,860,000 3,919,200 4,342,560 4,681,248 4,952,198 5,168,959 5,342,367
40%
NI 7,290,000 5,878,800 6,513,840 7,021,872 7,428,298 7,753,438 8,013,550
9-10
Add CCA 2,940,000 5,292,000 4,233,600 3,386,880 2,709,504 2,167,603 1,734,083
Cash flows 10,230,000 11,170,800 10,747,440 10,408,752 10,137,802 9,921,041 9,747,633
from
operations
Total Cash -$30,800,000 $10,230,000 $11,170,800 $10,747,440 $10,408,752 $10,137,802 $9,921,041 $11,147,633
flows
And the NPV is:
NPV= –$30,800,000 + $10,230,000 / 1.14 + $11,170,800 / 1.142+ $10,747,440 / 1.143

+ $10,408,752 / 1.144 + $10,137,802 / 1.145 + $9,921,041 / 1.146 + $11,147,633 / 1.147
NPV = $14,426,444.
So, the sensitivity of the NPV to changes in the price of the new club is:
NPV/P = (12,882,655 − $14,426,444) / ($875 – $885)

NPV/P = $154,378.90
For every dollar increase (decrease) in the price of the clubs, the NPV will increase (decrease)
by $154,378.90.
To calculate the sensitivity of the NPV to changes in the quantity sold of the new club, we
simply need to change the quantity sold. We will choose 65,000 units, but the choice is
irrelevant as the sensitivity will be the same no matter what quantity we choose.
We will calculate the sales and variable costs first. Since we will lose sales of the expensive
clubs and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales
for the new project will be:
Sales
New clubs $875  65,000 = $56,875,000
Exp. clubs $1,100  (– 12,000) = -$13,200,000
Cheap clubs $400  15,000 = $6,000,000
$49,675,000
Var. costs
New clubs –$430  65,000 = –$27,950,000
Exp. clubs –$620  (–12,000) = $7,440,000
Cheap clubs –$210  15,000 = –$3,150,000
–$23,660,000

9-11
The pro forma income statement and OCF will be:
WC -$1,400,000 $1,400,000
Sales $49,675,000 $49,675,000 $49,675,000 $49,675,000 $49,675,000 $49,675,000 49,675,000
Variable costs -23,660,000 -23,660,000 -23,660,000 -23,660,000 -23,660,000 -23,660,000 -23,660,000
Fixed costs -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000
CCA at 20% -2,940,000 -5,292,000 -4,233,600 -3,386,880 -2,709,504 -2,167,603 -1,734,083

EBIT 13,775,000 11,423,000 12,481,400 13,328,120 14,005,496 14,547,397 14,980,917
Taxes at 40% 5,510,000 4,569,200 4,992,560 5,331,248 5,602,198 5,818,959 5,992,367
NI 8,265,000 6,853,800 7,488,840 7,996,872 8,403,298 8,728,438 8,988,550
Add CCA 2,940,000 5,292,000 4,233,600 3,386,880 2,709,504 2,167,603 1,734,083

Cash flows from 11,205,000 12,145,800 11,722,440 11,383,752 11,112,802 10,896,041 10,722,633
operations
Total Cash flows -$30,800,000 $11,205,000 $12,145,800 $11,722,440 $11,383,752 $11,112,802 $10,896,041 $12,122,633
The NPV at this quantity is:
NPV= –$30,800,000 + $11,205,000/1.14 + $12,145,880/1.142+$11,722,440/1.143

+ $11,383,752/1.144 + $11,112,802 / 1.145 + $10,896,041 / 1.146 +$12,122,633 / 1.147
NPV = $18,607,542
So, the sensitivity of the NPV to changes in the quantity sold is:
NPV/Q = ($12,882,655 – $18,607,542) / (60,000 – 65,000)

NPV/Q = $1,144.98
For an increase (decrease) of one set of clubs sold per year, the NPV increases (decreases) by
$1,144.98.
9.12 a. The base-case NPV is:

10
NPV = –$1,350,000 + $315,000 Α 16%
NPV = $172,466.66
b. We would abandon the project if the cash flow from selling the equipment is greater than
the present value of the future cash flows. We need to find the sale quantity where the two
are equal, so:
9
$950,000 = ($35) × Q × Α 16%
Q = $950,000 / ($35 × 4.6065)
Q = 5,892

9-12
Abandon the project if Q < 5,892 units, because the NPV of abandoning the project is
greater than the NPV of the future cash flows of keeping the project.
c. The $950,000 is the market value of the project. If you continue with the project in one
year, you forego the $950,000 that could have been used for something else.
9.13a. If the project is a success, the expected sales will be revised upwards to 11,000 units. The
present value of the future cash flows will be:
9
PV future CFs = $35 × 11,000 units × Α 16%
PV future CFs = $1,773,519.39
From the previous question, if the quantity sold is 4,000 units, we would abandon the
project, and the cash flow would be $950,000. Since the project has an equal likelihood of
success or failure in one year, the expected value of the project in one year is the average of
the success and failure cash flows, plus the average cash flow in one year, so:
Expected value of project at the end of year 1 = [($1,773,519.39 + $950,000) / 2]

+ [($35 x 11,000 + $35 x 4,000) / 2]
Expected value of project at the end of year 1 = $1,624,259.70
The NPV is the present value of the expected value in one year plus the cost of the
equipment, so:
NPV = –$1,350,000 + $1,624,259.70 / 1.16

NPV = $50,223.88
b. If we couldn’t abandon the project, the present value of the future cash flows when the
quantity is 4,000 will be:
9
PV future CFs = $644,916.14
The gain from the option to abandon is the abandonment value minus the present value of
the cash flows if we cannot abandon the project, so:
Gain from option to abandon = $950,000 – $644,916.14

Gain from option to abandon = $305,083.56
The value of the option to abandon today is the likelihood of abandonment times the gain
from option to abandon discounted back to the present:
1
Option value = (.50) × ($305,083.56) × Α 16%
Option value = $131,501.53
9-13
9.14If the project is a success, present value of the future cash flows will be:
9
PV future CFs = $3,547,038.78
If the sales are only 4,000 units, from Problem #9.12 and #9.13, we know we will abandon the
project, with a value of $950,000. Since the project has an equal likelihood of success or failure
in one year, the expected value of the project in one year is the average of the success and failure
cash flows, plus the average cash flow in one year, so:
Expected value of project at year 1 = [($3,547,038.78+ $950,000) / 2]

+ [($35 x 11,000 + $35 x 4,000) / 2]
Expected value of project at year 1 = $2,511,019.39
The NPV is the present value of the expected value in one year plus the cost of the
equipment,so:
NPV = –$1,350,000 + $2,511,019.39 / 1.16

NPV = $814,671.89
The gain from the option to expand is the present value of the cash flows from the additional
units sold, so:
9
Gain from option to expand = $35 × 11,000 × Α 16%
Gain from option to expand = $1,773,519.39
The value of the option to expand today is the likelihood of expansion times the gain from
option to expand discounted back to the present:
Option value = (.50 × $1,773,519.39) / 1.16

Option value = $764,448.01
9.15 The accounting breakeven is the after-tax sum of the fixed costs and depreciation charge divided
by the contribution margin (selling price minus variable cost). In this case, there are no fixed
costs, and the depreciation is the entire price of the press in the first year. So, the accounting
breakeven level of sales is:
Q = [(Fixed cost + Depreciation) × (1 – TC)] / [(Sale price – Variable cost) × (1 – TC)]

Q = [($0 + 5,600) × (1 – 0.30)] / [($10 – 4.5) (1 – 0.30)]
Q = 1,018.18 or 1,018 units
9.16 The payoff from taking the lump sum is $12,000, so we need to compare this to the expected
payoff from taking one percent of the profit. The decision tree for the movie project is:

9-14
Big
audience
30% $20,000,00
0
Movie is
good
Make
10% movie
Script is Movie is
good bad
Read Small
script 70% audience
Script is
bad No profit
Don't
make
90% movie
No profit
The value of one percent of the profits is as follows. There is a 30 percent probability the movie is
good, and the audience is big, so the expected value of this outcome is:
Value = $20,000,000 × 0.30

Value = $6,000,000
The expected value if the movie is good, and has a big audience, assuming the script is good is:
Value = $6,000,000 × 0.10

Value = $600,000
Carl, the screenwriter will receive only one percent of this amount. So, the payment to the
screenwriter will be:
Payment to screenwriter = $600,000 × 0.01

Payment to screenwriter = $6,000
Therefore, Carl should take the upfront offer of $12,000.

9-15
9.17 We can calculate the value of the option to wait to open the mine as the difference between the
NPV of opening the mine today and the NPV of waiting one year to open the mine.
The remaining life of the mine = 48,000 ounces / 6,000 ounces per year = 8 years
This will be true no matter when you open the mine. The after-tax cash flow per year if opened
today is:
After-tax CF = 6,000 × $1,400 = $8,400,000
So, the NPV of opening the mine today is:

8
NPV = –$34,000,000 + $8,400,000 × Α 12%
NPV = $7,728,174.04
If you open the mine in one year, the cash flow will be either:
CFUp = 6,000 × $1,600 = $9,600,000 per year

CFDown = 6,000 × $1,300 = $7,800,000 per year
The PV of these cash flows is:

8
Price increase CF = $9,600,000 × Α 12 % = $47,689,341.76
Price decrease CF = $7,800,000 × Α 812 % = $38,747,590.18
So, the NPV in one year will be:
NPV in one year = –$34,000,000 + [(0.60 × $47,689,341.76) + (0.40 × $38,747,590.18)]

NPV in one year = $10,112,641.13
And the NPV today is:
NPV today = $10,112,641.13 / 1.12

NPV today = $9,029,143.87
So, the value of the option to wait is:
Value of the option to wait = $9,029,143.87 – $7,728,174.04

Value of the option to wait = $1,300,969.83
9.18 a. The NPV of the project is sum of the present value of the cash flows generated by the project.
The initial investment = $51 million
Annual operating cash flow for the next 10 years = $10.5 million
Discount rate = 13%

9-16
10
NPV = –$51,000,000 + $10,500,000 Α 13%
NPV = $5,975,556.50
b. The company should abandon the project if the PV of the revised cash flows for the next nine
years is less than the project’s after-tax salvage value. Since the option to abandon the project
occurs in year 1, discount the revised cash flows to year 1 as well. To determine the level of
expected cash flows below which the company should abandon the project, calculate the
equivalent annual cash flows the project must earn to equal the after-tax salvage value. We
will solve for C2, the revised cash flow beginning in year 2. So, the revised annual cash flow
below which it makes sense to abandon the project is:
9
After-tax salvage value = C2 × Α 13%
9
$31,000,000 = C2 × Α 13%
9
C2 = $31,000,000 / Α 13%
C2 = $6,040,935.96
9.19 a. The NPV of the project is sum of the present value of the cash flows generated by the
project. The annual cash flow for the project is the number of units sold times the cash flow
per unit, which is:
Annual cash flow = 15 units × $305,000

Annual cash flow = $4,575,000
The cash flows from this project are an annuity, so the NPV is:
5
NPV = –$15,000,000 + $4,575,000 × Α 16%
NPV = –$20,106.53
b. The company will abandon the project if unit sales are not revised upward. If the unit sales
are revised upward, the after-tax cash flows for the project over the last four years will be:
New annual cash flow = 20 units × $305,000

New annual cash flow = $6,100,000
The NPV of the project will be the initial cost, plus the expected cash flow in year one
based on 15 unit sales projection, plus the expected value of abandonment, plus the
expected value of cash flow after year one for next four years on 20 units sales projection.
We need to remember that the abandonment value occurs in year one, and the present value
of the expansion cash flows are in year one, so each of these must be discounted back to
today. So, the project NPV under the abandonment or expansion scenario is:

9-17
NPV = –$15,000,000 +$4,575,000 /1.16+0.50 ×($11,000,000)/1.16
4
+[0.50 × $6,100,000( Α 16% )] /1.16
NPV = $1,042,630.13
9.20 To calculate the unit sales for each scenario, we multiply the market sales times the company’s
market share.
We can then use the quantity sold to find the revenue each year, and the variable costs each
year. After doing these calculations, we will construct the pro forma income statement for each
scenario. We can then find the operating cash flow using the bottom up approach, which is net
income plus depreciation. Doing so, we find:
Pessimistic Expected Optimistic

Units sold per year 27,300 37,500 46,200

$3,822,000.0 $5,437,500.0
Revenue 0 0 $6,930,000.00
Variable costs 2,784,600.00 3,675,000.00 4,342,800.00
Fixed costs 1,015,000.00 950,000.00 900,000.00
Depreciation 366,666.67 350,000.00 333,333.33
EBT –$344,266.67 $462,500.00 $1,353,866.67
Tax –137,706.67 185,000.00 541,546.67
Net income –$206,560.00 $277,500.00 $812,320.00
OCF $160,106.67 $627,500.00 $1,145,653.33
Note that under the pessimistic scenario, the taxable income is negative. We assumed a tax
credit in the case. Now we can calculate the NPV under each scenario, which will be:
6
NPVPessimistic = –$2,200,000 + $160,106.67 Α 13%
NPV = –$1,559,965.63
6
NPVExpected = –$2,100,000 +$627,500 Α 13 %
NPV = $408,462.49
6
NPVOptimistic = –$2,000,000 +$1,145,653.33 Α 13 %
NPV = $2,579,806.24
The NPV under the pessimistic scenario is negative, so the company may accept the project only
if the likelihood of occurrence of the pessimistic scenario is very low.

9-18
9.21a. Using the bottom up approach, the OCF is:
Investment –$2,900,000 $300,000

WC –450,000 450,000
Sales $12,075,000 $12,075,000 $12,075,000 $12,075,000 12,075,000
Variable costs –9,975,000 –9,975,000 –9,975,000 –9,975,000 –9,975,000
Fixed costs –495,000 –495,000 –495,000 –495,000 –495,000
CCA at 30% –435,000 –739,500 –517,650 –362,355 –253,649
EBIT 1,170,000 865,500 1,087,350 1,242,645 1,351,352
Taxes at 38% 444,600 328,890 413,193 472,205 513,514
NI 725,400 536,610 674,157 770,440 837,838
Add back CCA 435,000 739,500 517,650 362,355 253,649
Cash flow from 1,160,400 1,276,110 1,191,807 1,132,795 1,091,486
operations
Total cash flows –$3,350,000 $1,160,400 $1,276,110 $1,191,807 $1,132,795 $1,841,486
And the NPV is:
NPV =–$3,350,000 + $1,160,400/1.13 + $1,276,110/1.132+ $1,191,807/1.133 + $1,132,795/1.134

+ $1,841,486/1.135
NPV = $1,196,515
Since the NPV of this project is positive, it should be accepted.

b. In the worst-case, the OCF is:
Investment –$3,335,000 $255,000

WC –472,500 472,500
Sales $10,867,500 $10,867,500 $10,867,500 $10,867,500 10,867,500
Variable costs –9,975,000 –9,975,000 –9,975,000 –9,975,000 –9,975,000
Fixed costs –495,000 –495,000 –495,000 –495,000 –495,000
CCA at 30% –500,250 –850,425 –595,298 –416,708 –291,696
EBIT –102,750 –452,925 –197,798 –19,208 105,804
Taxes at 38% –39,045 –172,112 –75,163 –7,299 40,206
NI –63,705 –280,814 –122,634 –11,909 65,599
Add back CCA 500,250 850,425 595,298 416,708 291,696
Cash flow from 436,545 569,612 472,663 404,799 357,294
operations
Total cash flows –$3,807,500 $436,545 $569,612 $472,663 $404,799 $1,084,794
And the worst-case NPV is:
NPVworst = –$3,807,500 + $436,545/1.13 + $569,612/1.132 + $472,663/1.133 + $404,799/1.134

+ $1,084,794/1.135
NPVworst = –$1,810,455

9-19
The best-case OCF is:
Investment –$2,465,000 $345,000

WC –427,500 427,500
Sales $13,282,500 $13,282,500 $13,282,500 $13,282,500 13,282,500
Variable costs –9,975,000 –9,975,000 –9,975,000 –9,975,000 –9,975,000
Fixed costs –495,000 –495,000 –495,000 –495,000 –495,000
CCA at 30% –369,750 –628,575 –440,003 –308,002 –215,601
EBIT 2,442,750 2,183,925 2,372,498 2,504,498 2,596,899
Taxes at 38% 928,245 829,892 901,549 951,709 986,822
NI 1,514,505 1,354,034 1,470,948 1,552,789 1,610,077
Add back CCA 369,750 628,575 440,003 308,002 215,601
Cash flow from 1,884,255 1,982,609 1,910,951 1,860,791 1,825,678
operations
Total cash flows –$2,892,500 $1,884,255 $1,982,609 $1,910,951 $1,860,791 $2,598,178
And the best-case NPV is:
NPVbest = –$2,892,500 + $1,884,255/1.13 + $1,982,609/1.132+ $1,910,951/1.133

+ $1,860,791/1.134 + $2,598,178/1.135
NPVbest = $4,203,485
If the worst-case scenario is likely, the firm should not accept the project.
9.22To calculate the sensitivity to changes in quantity sold, we will choose a quantity of 36,000.
First, calculate the EACPVCCATS as follows:
CD T c 1+0.5 k SxDxT c 1
PVCCATS= x − x
k +d 1+k k +d (1+ k )n
$ 2 ,900 ,000(0.30)(0 .38) 1 .065 $ 300,000(0 .30)(0 .38) 1

PVCCATS= × − ×
0.3+0 .13 1 .13 0.3+0.13 1.135
=$ 681,443.71
5
EACPVCCATS = $ 681,443.71 / Α 13 % = $193,744.36
The OCF at this level of sales is:
OCF = [($345 – $285) × (36,000) – $495,000] × (0.62) + $193,744.36

OCF = $1,226,044.36
The OCF at the level of Sales of 35,000 is:
OCF = [($345 – 285) × (35,000) – $495,000] × (0.62) + $193,744.36

OCF = $1,188,844.36
9-20
The sensitivity of changes in the OCF to quantity sold is:
OCF/Q = ($1,188,844.36 – $1,226,044.36)/(35,000 – 36,000)

OCF/Q = +$37.2
The pro forma income statement and OCF at the level of Sales of 36,000:
Investment –$2,900,000 $300,000

WC –450,000 450,000
Sales $12,420,000 $12,420,000 $12,420,000 $12,420,000 12,420,000
Variable costs –10,260,000 –10,260,000 –10,260,000 –10,260,000 –10,260,000
Fixed costs –495,000 –495,000 –495,000 –495,000 –495,000
CCA at 30% –435,000 –739,500 –517,650 –362,355 –253,649
EBIT 1,230,000 925,500 1,147,350 1,302,645 1,411,352
Taxes at 38% 467,400 351,690 435,993 495,005 536,314
NI 762,600 573,810 711,357 807,640 875,038
Add back CCA 435,000 739,500 517,650 362,355 253,649
Cash flow from 1,197,600 1,313,310 1,229,007 1,169,995 1,128,686
operations
Total cash flows –$3,350,000 $1,197,600 $1,313,310 $1,229,007 $1,169,995 $1,878,686
The NPV at this level of sales is:
NPV = – $3,350,000 + $1,197,600/1.13 + $1,313,310/1.132+ $1,229,007/1.133

+ $1,169,995/1.134 + $1,878,686/1.135
NPV = $1,327,356
And the sensitivity of NPV to changes in the quantity sold is:
NPV/Q = ($1,327,356 – $1,196,515) / (36,000 – 35,000)

NPV/Q = +$130.84
You wouldn’t want the quantity to fall below the point where the NPV is zero. We know the
NPV changes $130.84 for every unit sale, so we can divide the NPV for 35,000 units by the
sensitivity to get a change in quantity. Doing so, we get:
$1,196,515 = $130.84 (Q)

Q = 9,144.87 or 9,145
For a zero NPV, sales would have to decrease 9,145 units, so the minimum quantity is:
QMin = 35,000 – 9,145

QMin = 25,855

9-21
9.23We will use the bottom up approach to calculate the operating cash flow. Assuming we operate
the project for all four years, the cash flows are:
$6,850,00 $6,850,00 $6,850,00 $6,850,00

Sales
0 0 0 0
– – – –
Operating costs
2,800,000 2,800,000 2,800,000 2,800,000
– – – –
Depreciation
2,000,000 2,000,000 2,000,000 2,000,000
EBT 2,050,000 2,050,000 2,050,000 2,050,000
Tax 779,000 779,000 779,000 779,000
Net income 1,271,000 1,271,000 1,271,000 1,271,000
+Depreciation 2,000,000 2,000,000 2,000,000 2,000,000
Operating CF 3,271,000 3,271,000 3,271,000 3,271,000
Change in NWC –$950,000 950,000
Capital
–8,000,000
spending
− $3,271,00 $3,271,00 $3,271,00 $4,221,00
Total cash flows
$8,950,000 0 0 0 0
There is no salvage value for the equipment. The NPV is:

4
NPV = –$8,950,000 + $3,271,000 × Α 16% + $950,000/1.164
NPV = $727,525
The cash flows if we abandon the project after one year are:
Sales $6,850,000
Operating costs –2,800,000
Depreciation –2,000,000
EBT 2,050,000
Tax $779,000
Net income 1,271,000
+Depreciation 2,000,000
Operating CF 3,271,000
Change in NWC –$950,000 950,000
Capital spending –8,000,000 5,442,000
Total cash flow –$8,950,000 $9,663,000
The book value of the equipment is:
Book value = $8,000,000 – (1) × ($8,000,000/4)

Book value = $6,000,000
So the tax savings on the terminal loss will be:

9-22
Taxes = ($6,000,000 – 5,100,000) × (0.38)
Taxes = $342,000
This makes the after-tax salvage value:
After-tax salvage value = $5,100,000 + 342,000

After-tax salvage value = $5,442,000
The NPV if we abandon the project after one year is:
NPV = –$8,950,000 + $9,663,000/1.16

NPV = –$619,828
If we abandon the project after two years, the cash flows are:
Sales $6,850,000 $6,850,000

Operating costs –2,800,000 –2,800,000
Depreciation −2,000,000 −2,000,000
EBT 2,050,000 2,050,000
Tax 779,000 779,000
Net income 1,271,000 1,271,000
+Depreciation 2,000,000 2,000,000
Operating CF 3,271,000 3,271,000
950,00
Change in NWC –$950,000
0
3,876,00
Capital spending –8,000,000
0
Total cash flows –$8,950,000 $3,271,000 $8,097,000
Book value = $8,000,000 – (2) × ($8,000,000/4)

Book value = $4,000,000
So the tax savings on the terminal loss will be:
Taxes = ($4,000,000 – 3,800,000) × (0.38)

Taxes = $76,000
After-tax salvage value = $3,800,000 + 76,000

The NPV if we abandon the project after two years is:

9-23
NPV = –$8,950,000 + $3,271,000/1.16 + $8,097,000/1.162
NPV = –$112,782
If we abandon the project after three years, the cash flows are:
Sales $6,850,000 $6,850,000 $6,850,000

Operating costs –2,800,000 –2,800,000 –2,800,000
Depreciation –2,000,000 –2,000,000 –2,000,000
EBT 2,050,000 2,050,000 2,050,000
Tax 779,000 779,000 779,000
Net income 1,271,000 1,271,000 1,271,000
+Depreciation 2,000,000 2,000,000 2,000,000
Operating CF 3,271,000 3,271,000 3,271,000
Change in NWC –950,000 950,000
Capital spending –8,000,000 2,744,000
Total cash flows –$8,950,000 $3,271,000 $3,271,000 $6,965,000
Book value = $8,000,000 – (3) × ($8,000,000/4)

Book value = $2,000,000
So the taxes on the recaptured depreciation will be:
Taxes = ($3,200,000 – 2,000,000) × (0.38)

Taxes = $456,000
After-tax salvage value = $3,200,000 - 456,000

The NPV if we abandon the project after three years is:
NPV = –$8,950,000 + $3,271,000/1.16 + $3,271,000/1.162 + $6,965,000/1.163

NPV = $762,894
We should abandon the equipment after three years since the NPV of abandoning the project
after three years has the highest NPV.
9.24 a. The NPV of the project is the sum of the present value of the cash flows generated by the
project. The cash flows from this project are an annuity, so the NPV is:
10
NPV = –$7,000,000 + $1,300,000 Α 10 %
9-24
NPV = $987,937.24
b. The company will abandon the project if the value of abandoning the project is greater than
the value of the future cash flows. The present value of the future cash flows if the company
revises it sales downward will be:
9
PV of downward revision = ($285,000 x Α 10 % ) / 1.10
PV of downward revision = $1,492,110.72
Since this is less than the value of abandoning the project, the company should abandon in
one year under the downward revision scenario. So, the revised NPV of the project will be
the initial cost, plus the expected cash flow in year one based on upward sales projection,
plus the expected value of abandonment. We need to remember that the abandonment value
occurs in year 1, and the present value of the expansion cash flows are in year one, so each
of these must be discounted back to today. So, the project NPV under the abandonment or
expansion scenario is:
NPV = –$7,000,000 + $1,300,000 / 1.10 + .50 × ($2,600,000) / 1.10

9
+ [0.50 × $2,200,000 × Α 10 % ] / 1.10
NPV = $1,122,660.18

9-25
MINI-CASE: Bunyan Lumber LLC
The company is faced with the decision of when to harvest the lumber. Whatever harvest cycle
the company chooses, it will follow that cycle in perpetuity. Since the forest was planted 20
years ago, the options available in the case are 40, 45, 50, and 55-year harvest cycles. No matter
what harvest cycle the company chooses, it will always thin the timber 20 years after harvests
and replants. The cash flows will grow at the inflation rate, so we can use the real or nominal
cash flows. In this case, it is simpler to use real cash flows, although nominal cash flows would
yield the same result. So, the real required return on the project is:
(1 + R) = (1 + r)(1 + h)
1.10 = (1 + r)(1.037)
r = 0.0608 or 6.08%
The conservation funds are expected to grow at a slower rate than inflation, so the real return for
the conservation fund will be:
(1 + R) = (1 + r)(1 + h)
1.10 = (1 + r)(1.032)
r = 0.0659 or 6.59%
The company will thin the forest today regardless of the harvest schedule, so this first thinning is
not an incremental cash flow, but future thinning is part of the analysis since the thinning
schedule is determined by the harvest schedule. The cash flow from the thinning process is:
Cash flow from thinning = Acres thinned × Cash flow per acre
Cash flow from thinning = 5,000 × ($1,000)
Cash flow from thinning = $5,000,000
The real cost of the conservation fund is constant, but the expense will be tax deductible, so the
after-tax cost of the conservation fund will be:
After-tax conservation fund cost = (1 – 0.35) × ($250,000)

After-tax conservation fund cost = $162,500
For each analysis, the revenue and costs are:
Revenue = [∑(% of grade)(harvest per acre)(value of board grade)](acres harvested)

(1 – defect rate)
Tractor cost = (Cost MBF)(MBF per acre)(acres)
Road cost = (Cost MBF)(MBF per acre)(acres)
Sale preparation and administration = (Cost MBF)(MBF acre)(acres)
Excavator piling, broadcast burning, site preparation, and planting costs are the cost of each per
acre times the number of acres. These costs are the same no matter what the harvest schedule
since they are based on acres, not MBF.
9-26
Now we can calculate the cash flow for each harvest schedule. One important note is that no
depreciation is given in the case. Since the harvest time is likely to be short, the assumption is
that no depreciation is attributable to the harvest. This implies that operating cash flow is equal
to net income. Next we can calculate the NPV of each harvest schedule. The NPV of each
harvest schedule is the NPV of the first harvest, the NPV of the thinning, the NPV of all future
harvests, minus the present value of the conservation fund costs.
Harvest in 20 years
Revenue $40,359,135
Tractor cost 9,870,000
Road 3,525,000
Sale preparation & admin 1,269,000
Excavator piling 875,000
Broadcast burning 1,550,000
Site preparation 750,000
Planting costs 1,125,000
EBIT 21,395,135
Taxes 7,488,297
Net income (OCF) $13,906,838
The PV of the first harvest in 20 years is:
PVFirst = $13,906,838/(1 + 0.0608)20

PVFirst = $4,275,135
Thinning will also occur on a 40-year schedule, with the next thinning 40 years from today. The
effective 40-year interest rate for the project is:
40-year project interest rate = [(1 + .0608)40] – 1

40-year project interest rate = 958.17%
We also need the 40-year interest rate for the conservation fund, which will be:
40-year conservation interest rate = [(1 + .0659)40] – 1

40-year conservation interest rate = 1,183.87%
Since we have the cash flows from each thinning, and the next thinning will occur in 40 years,
we can find the present value of future thinning on this schedule, which will be:
PVThinning = $5,000,000/9.5817
PVThinning = $521,825.80

9-27
The operating cash flow from each harvest on the 40-year schedule is $13,906,838, so the present
value of the cash flows from the harvest are:
PVHarvest = [($13,906,838/9.5817)] / (1 + 0.0608)20

PVHarvest = $446,175.14
Now we can find the present value of the conservation fund deposits. The present value of these
deposits at Year 20 is:
PVConservation = –$162,500 – $162,500/11.8387

PVConservation = –$176,226.22
And the value today is:

PVConservation = –$176,226.22/(1 + 0.0659)20
So, the NPV of a 40-year harvest schedule is:
NPV = $4,275,135 + $521,825.80 + $446,175.14 – 49,182.52

NPV = $5,193,953.29
Harvest in 25 years:
Revenue $47,051,600
Road 4,100,000
EBIT 25,695,600
Taxes 8,993,460
PVFirst = $16,702,140 /(1 + 0.0608)25

PVFirst = $3,823,173

9-28
45-year project interest rate = [(1 + 0.0608)45] – 1
45-year project interest rate = 1,321.11%
45-year conservation interest rate = [(1 + 0.0659)45] – 1

PVThinning = $5,000,000/13.2111
The operating cash flow from each harvest on the 45-year schedule is $16,702,140, so the
present value of the cash flows from the harvest are:
PVHarvest = [($16,702,140 /13.2111)] / (1 + 0.0608)25

PVHarvest = $289,391.58
deposits is at Year 25 is:
PVConservation = –$162,500 – $162,500/16.6638


PVConservation = –$172,251.64/(1 + 0.0659)25
NPV = $3,823,173 + $378,470.46 + $289,391.58 – $34,941.27
NPV = $4,456,093.33

9-29
Harvest in 30 years
Revenue $49,699,440
Road 4,325,000
EBIT 27,407,440
Taxes 9,592,604
PVFirst = $17,814,836 /(1 + 0.0608)30

PVFirst = $3,036,435


PVThinning = $5,000,000/18.0852
The operating cash flow from each harvest on the 50-year schedule is $17,814,836 , so the
PVHarvest = [($17,814,836 /18.0852] / (1 + 0.0608)30

PVHarvest = $167,896.23
9-30
PVConservation = –$162,500 – $162,500/23.3024

PVConservation = –$169,473.53/(1 + 0.0659)30
PVConservation = – $24,986.89
NPV = $3,036,435 + $276,469.34 + $167,896.23 – $24,986.89

NPV = $3,455,813.52
Harvest in 35 years
Revenue $52,057,863
Road 4,525,000
EBIT 28,933,863
Taxes 10,126,852
PVFirst = $18,807,011 / (1 + 0.0608)35

PVFirst = $2,386,889



9-31
PVThinning = $5,000,000/24.6310
The operating cash flow from each harvest on the 55-year schedule is $20,535,286, so the
PVHarvest = [($18,807,011 /24.6310] / (1 + 0.0608)35

PVHarvest = $96,905.78
PVConservation = –$162,500 – $162,500/32.4360

PVConservation = –$167,509.87/(1 + 0.0659)35

NPV = $2,386,889 + $202,995.97 + $96,905.78 –$17,950.88

NPV = $2,668,840.08
The company should harvest in 20 years since it has the highest NPV. Notice that when the NPV
began to decline, it continued declining. This is expected since the growth in the trees increases
at a decreasing rate. So, once we reach a point where the increased growth cannot overcome the
increased effects of compounding, harvesting should take place. There is no point further in the
future which will provide a higher NPV.

9-32

Chapter 9: Risk Analysis, Real Options, and Capital Budgeting Questions and Problems: 9.1 A

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Chapter 9: Risk Analysis, Real Options, and Capital Budgeting Questions and Problems: 9.1 A

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Chapter 9: Risk Analysis, Real Options, and Capital Budgeting

Questions and Problems:

And the accounting breakeven is:

QA = ($850,000 + $90,500) / ($39 – $23)

OCFnew = [($39 – $23) × (80,000) – $850,000] × (0.65) + 0.35 × ($90,500)

And the NPV is:

NPV/S = ($439,001.55 – $672,342.27) / (75,000 – 80,000)

Ross et al, Corporate Finance 8th Canadian Edition Solutions Manual

NPV drop = $46.668 × (500) = $23,334.07

OCFnew = [($39 – $24) × (75,000) – $850,000] × (0.65) + 0.35 × ($90,500)

So, the decrease in OCF for a $1 increase in variable costs is:

OCF/v = ($259,175 – $210,425) / ($23 – $24)

If variable costs decrease by $1 then, OCF would increase by $48,750.

The best-case NPV is:

9.3 We can use the accounting breakeven equation:

QA = (Fixed cost + Depreciation) / (Price – Variable cost)

(1): QA = 95,300 = ($820,000 + Depreciation) / ($41 – $30)

(2): QA = 143,806 = ($2.75 million + $1.15 million) / (P – $56)

(3): QA = 7,835 = ($160,000 + $105,000) / ($97 – v)

Ross et al, Corporate Finance 8th Canadian Edition Solutions Manual

NPV = CSuccess × (Prob. of Success) + CFailure × (Prob. of Failure)

NPV= C0 + {[CSuccess (Prob. of Success)] + [CFailure (Prob. of Failure)]} / (1 + r)t

NPV = CSuccess (Prob. of Success)

The NPV of the focus group is:

NPV = C0 + CSuccess × (Prob. of Success)

And the NPV of using the consulting firm is:

NPV = C0 + CSuccess × (Prob. of Success)

NPV = CSuccess × (Prob. of Success) + CFailure × (Prob. of Failure)

NPV= C0 + {[CSuccess (Prob. of Success)] + [CFailure (Prob. of Failure)]} / (1 + r)t

OCF = [($37 – $23) × (91,000) – $195,000] × (1 – 0.34) + 0.34 − ($480,000 / 4 years)

The sensitivity of the OCF to changes in the quantity sold is:

Sensitivity = OCF/Q = ($743,700 – $752,940) / (90,000 – 91,000)

Ross et al, Corporate Finance 8th Canadian Edition Solutions Manual

OCFbase = [($18,000 – $15,400) × (450) – $610,000] × (0.65)

PV of CCA Tax Shield :

OCFworst = [($18,000 – $16,940)(405) – $671,000](0.65)

PV of CCA Tax Shield :

OCFbest = [($18,000 – $13,860)(495) – $549,000](0.65)

PV of CCA Tax Shield :

$ 820 ,000×0 . 20×0 . 35 1+(0 .5×0 . 15)

OCF = [($18,000 – $15,400)(450) – $620,000](0.65)

And the NPV is:

The sensitivity of NPV to changes in fixed costs is:

NPV/FC = ($372,516.47– $353,959.29) / ( $610,000 – $620,000)

For every dollar FC increase, NPV falls by $1.86.

c. Convert PVCCATS to an EAC:

Convert the initial investment to an EAC:

Financial break-even is:

Ross et al, Corporate Finance 8th Canadian Edition Solutions Manual

So, the payback period is:

Payback period = 2 years + $8,719,200 / $10,387,440

The NPV is:

NPV = –$30,800,000 + $9,870,000 / 1.14 + $10,810,800/1.142+ $10,387,440/1.143

Ross et al, Corporate Finance 8th Canadian Edition Solutions Manual

NPV= –$30,800,000 + $9,870,000 / (1+IRR) + $10,810,800 / (1+IRR)2

The pro forma income statement and OCF will be:

And the NPV is:

NPV= –$30,800,000 + $10,230,000 / 1.14 + $11,170,800 / 1.142+ $10,747,440 / 1.143

NPV/P = (12,882,655 − $14,426,444) / ($875 – $885)

Ross et al, Corporate Finance 8th Canadian Edition Solutions Manual

Sales $49,675,000 $49,675,000 $49,675,000 $49,675,000 $49,675,000 $49,675,000 49,675,000

Variable costs -23,660,000 -23,660,000 -23,660,000 -23,660,000 -23,660,000 -23,660,000 -23,660,000

Fixed costs -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000 -9,300,000