Session 1 Solution

1.
a. (Revenue – expenses) changes by $1 million – $0.5 million = $0.5 million.
After-tax profits increase by $0.5 million  (1 – 0.35) = $0.325 million.
Because depreciation is unaffected, cash flow changes by the same amount.

b. Expenses increase from $5 million to $6.5 million.

After-tax income and cash flow decrease by:
$1.5 million  (1 – 0.35) = $0.975 million
 1 1 
c. The 12%, 10-year annuity factor is:  − 10 
= 5.65022
 0.12 0.12  (1.12) 
2.

a. See Excel. NPV $2 million.

b. The effect on NPV equals the change in C  5.65022. $0.325 million  5.65022 = $1.836 million
$0.975 million  5.65022 = $5.509 million

c. Fixed costs can increase up to the point at which the higher costs (after taxes) reduce NPV by $2 million:
Increase in fixed costs  (1 – T)  annuity factor (12%, 10 years) = $2 million
Increase in fixed costs  (1 – 0.35)  5.65022 = $2 million
Increase in fixed costs = $544,567
3.

Why is sensitivity analysis useful? - Example

Base Case: Expected cash flows from a new project (with 8%
Opportunity Cost of Capital; 40% average tax rate; variable costs
are a constant 80% of sales; all numbers in $000s)
Year 0 Years 1-12
Investment -5,400 Calculate:
Sales 16,000
NPV = $1,382.47
Variable Costs (12,800)
Fixed Costs (2,000) IRR = 12.7%
Depreciation (450) Payback Period = 6 years
Pretax profit 750
Profitability Index = .256
Taxes (300)
Profit after tax 450
Operating cash flow 900
Net Cash Flow -5,400 900
10-
10-9

4.
Most Likely Best Case Worst Case
Price $50 $55 $45
Variable cost $30 $27 $33
Fixed cost $300,000 $270,000 $330,000
FIN520 Corporate Finance
chris.fitzsimons@isg.fr
Fitzsimons & Co. Eurl www.yourcfo.fr
Course notes to assist non Anglophone students. These notes are not to be copied or distributed outside the above-mentioned course. They are intended merely to
supplement private study. Reference must be made to the course textbook Brealey, Myers, Marcus Fundamentals of Corporate Finance (10th edition); McGraw Hill
International edition).Course URL version is recommended: https://connect.mheducation.com/class/c-fitzsimons-a-bmi-3-corporate-finance-group-1-and-group-2
 Sales 30,000 units 33,000 units 27,000 units
Cash flow = [(1 – T)  (revenue – cash expenses)] + (T  depreciation)
Depreciation expense = $1 million/10 years = $100,000 per year
12%, 10-year annuity factor as in question 2 = 5.65022
a. Base-case CF = 0.65  30,000  ($50 – $30) – $300,000] + (0.35  $100,000) = $230,000
Base-case NPV = (5.65022  $230,000) – $1,000,000 = $299,551
b. Best-case CF = 0.65  [33,000  ($55 – $27) – $270,000] + (0.35  $100,000) = $460,100
Best-case NPV = (5.65022  $460,100) – $1,000,000 = $1,599,666
c. Worst-case CF = 0.65  [27,000  ($45 – $33) – $330,000] + (0.35  $100,000) = $31,100
Worst-case NPV = (5.65022  $31,100) – $1,000,000 = –$824,278
d. If price is higher—for example, because of inflation—variable costs may also be higher. Similarly, if price is high
because of strong demand for the product, then sales may be higher. It doesn’t make sense to formulate a scenario
analysis in which uncertainty in each variable is treated independently of all other variables.

5. a. Each dollar of sales generates $0.60 or 60% of pretax profit. Depreciation expense is $100,000 per year, and fixed costs are
$200,000. Therefore:
Accounting break-even revenue = ($200,000 + $100,000)/60% = $500,000
Accounting break-even units = ($200,000 + $100,000)/$60. The firm must sell 5,000 diamonds annually.
b. Let Q = the number of diamonds sold.
Cash flow = [(1 – 0.35)  (revenue – expenses)] + (0.35  depreciation)
= [0.65  (100Q – 40Q – 200,000)] + (0.35  100,000)
= 39Q – 95,000
12%, 10-year annuity factor as in question 2 = 5.65022
Therefore, for NPV to equal zero:
(39Q – 95,000)  5.65022 = $1,000,000  Q = 6,974 diamonds per year.

FIN520 Corporate Finance

chris.fitzsimons@isg.fr
Fitzsimons & Co. Eurl www.yourcfo.fr
Course notes to assist non Anglophone students. These notes are not to be copied or distributed outside the above-mentioned course. They are intended merely to
supplement private study. Reference must be made to the course textbook Brealey, Myers, Marcus Fundamentals of Corporate Finance (10th edition); McGraw Hill
International edition).Course URL version is recommended: https://connect.mheducation.com/class/c-fitzsimons-a-bmi-3-corporate-finance-group-1-and-group-2