BUS 438 (Durham).

HW 8 — capital budgeting 3

1. What is forecasting risk? In general, would the degree of forecasting risk be greater for a new
product or a cost-cutting proposal? Why?

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

2. What is the main difference between sensitivity analysis and scenario analysis?

Solution:
With a scenario analysis, changes in several variables at a time are considered. With a
sensitivity analysis, only a single variable is changed.

3. A project has the following estimated data: price = $70 per unit; variable costs = $37 per
unit; fixed costs = $6,000; required return = 15 percent; initial investment = $12,000; life
= four years. Use straight-line depreciation over four years, and assume the project has no
salvage value. Assume the tax rate is 34%.
(a) What is the accounting break-even quantity?
(b) The cash break-even quantity (ignoring the depreciation tax shield)?
(c) The financial break-even quantity?
(d) Ignoring taxes, what is the degree of operating leverage if 300 units are sold?

Solution:

(a) Accounting break-even:

Q = (FC + D) / (P - VC)
= (6000 + 3000) / (70 - 37)
= 273

(b) Cash break-even:

Q = FC / (P - VC)
= 6000 / (70 - 37)
= 182

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 (c) To solve for the financial break-even, we first solve for the required OCF. Use your
calculator with PV=-12000, n=4, r=15%, FV=0. You should get PMT = OCF =
4203.18.
Now, use OCF = (Q · P − Q · V C − F C) · (1 − T ) + Depr · T , and solve for Q. You should
get
OCF − Depr · T + F C · (1 − T )
Q= = 327.97
(P − v) · (1 − T )
(d) And finally, operating leverage is:
DOL = Q*(P-v) / EBIT
= 300*(70-37) / (300*(70-37)-6000-3000)
= 11
This means that a 1% change in Q corresponds to a 11% change in EBIT.

4. We are evaluating a project that costs $896,000, has a eight-year life, and has no salvage
value. Assume that depreciation is straight-line to zero over the life of the project. Sales are
projected at 100,000 units per year. Price per unit is $38, variable cost per unit is $25, and
fixed costs are $900,000 per year. The tax rate is 35 percent, and we require a 15 percent
return on this project.

(a) Calculate the accounting break-even point. Also, find the DOL at this level of sales.
(b) Calculate the base-case cash flow and NPV. What is the sensitivity of NPV to changes in
the sales quantity (∆ NPV/∆ Sales)? What is the effect on NPV of a 500-unit decrease
in projected sales.
(c) What is the sensitivity of OCF to changes in the variable cost figure? What is the effect
on OCF of a $3 decrease in variable costs.
(d) Suppose the projections given for price, quantity, variable costs, and fixed costs are all
accurate to within ±10 percent. Calculate the best-case and worst-case NPV figures.

NOTE: You will probably want to use spreadsheet software to do the scenario and sensivity
analysis.

Solution:

(a) We first need to compute depreciation:

D = 896,000 / 8 = 112,000

Now, the accounting break-even is

Q = (FC + D) / (P - VC)
= (900,000 + 112,000) / (38 - 25)
= 77,846

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 To find the operating leverage, recall that OCF = Depr at the accounting break-even,
so
DOL = 1 + FC/OCF
= 1 + 900,000 / 112,000
= 9.036

(b) To get the base case NPV, first find the OCF:
OCF = (Sales - Costs) x (1 - T) + Depr x T
= (3,800,000 - 2,500,000 - 900,000) x .65
+ 112,000 x .35
= 299,200

There is no salvage value and no change in NWC. To get NPV, use your calculators
with an initial cash flow of -896,000 followed by eight cash flows of 299,200 each, and a
discount rate of 15%. You should get NPV = $446,606.60.
To calculate the sensitivity to quantity sold, repeat the above calculations for a different
value of Q, say, Q=101,000. You should obtain NPV = $484,525.46.
Thus, the change in NPV per unit change in Q is
(484,525.46 - 446,606.60) / (101,000 - 100,000) = 37.92.
In other words, for every additional unit sold, NPV increases by $37.92. A 500 unit
decrease in Q decreases NPV by 500 · 37.92 = $18960.
(c) To compute the sensitivity of OCF to change in VC, repeat the above calculations for
OCF (base case only) for a different value of VC, say, VC=24. You should find that
OCF=$364,200.
Thus, the change in OCF per unit change in VC is
(299,200 - 364,200) / (25 - 24) = -65,000.
That is, OCF decreases by $65,000 for every dollar increase in VC.
For a $3 decrease in VC, OCF increases by 3 · 65, 000 = $195, 000.
(d) To get the best case NPV, use P=41.80, Q=110,000, VC=22.50, and FC=810,000. Re-
peating the above calculations with these values, you should get OCF=$892,650 and
NPV=$3,109,607.54
For the worst case, use P=34.20, Q=90,000, VC=27.50, and FC=990,000. You should
obtain OCF = -$212,350 and NPV = -$1,848,882.72.

5. McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell for $700 per set and
have a variable cost of $320 per set. The company has spent $150,000 for a marketing study
that determined the company will sell 55,000 sets per year for seven years. The marketing
study also determined that the company will lose sales of 13,000 sets of its high-priced clubs.
The high-priced clubs sell at $1,100 and have variable costs of $600. The company will also
increase sales of its cheap clubs by 10,000 sets. The cheap clubs sell for $400 and have variable
costs of $180 per set. The fixed costs each year will be $7,500,000. The new clubs will also

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require an increase in net working capital of $950,000 that will be returned at the end of the
project. The company has also spent $1,000,000 on research and development for the new
clubs. The plant and equipment required will cost $18,200,000 and will be depreciated on a
straight-line basis over 10 years. The project will be ended after 7 years. There is no salvage
value. The tax rate is 40 percent, and the cost of capital is 14 percent.

(a) Calculate the payback period, the NPV, and the IRR.
(b) Suppose that you feel the values are accurate to within only plus or minus 10 percent.
What are the best-case and worst-case NPVs? (Hint: The price and variable costs for
the two existing sets of clubs are known with certainty; only the sales gained or lost are
uncertain.)
(c) McGilla Golf would like to know the sensitivity of NPV to changes in the price of the
new clubs and the quantity of new clubs sold. What is the sensitivity of the NPV to
each of these variables?
(d) What is the financial break-even?

Solution:

(a) The 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
erosion.
The total effect on sales if the project is undertaken will be:
Incremental sales = Sales of new clubs
- Lost sales of expensive clubs
+ Additional sales of cheap clubs
= (700 x 55,000)
- (1100 x 13,000)
+ (400 x 10,000)
= 28,200,000
The effect on variable costs is
Incremental VC = VC for new clubs
- Decrease in VC for expensive clubs
+ Increase in VC for cheap clubs
= (320 x 55,000)
- (600 x 13,000)
+ (180 x 10,000)
= 11,600,000
Since FC=7,500,000, we get
OCF = (Sales - VC - FC) x (1 - T) + Depr x T
= (28,200,000 - 11,600,000 - 7,500,000) x .60
+ 1,820,000 x .40
= 6,188,000

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 Although there is no salvage value, there is still a tax-shield for the plant equipment at
the end of the project.
ATSV = BTSV*(1-T) + EndBV*T
= 0.4*5460000
= 2,184,000
Since the initial cost is 18,200,000 + 950,000 = 19,150,000 (remember change in NWC!),
the payback period is 19,150,000 / 6,188,000 = 2.95 years.
To get the NPV, use your calculator with an initial cash flow of -19,150,000, six cash
flows of 6,188,000, and a final cash flow of 9,322,000 (OCF plus recovered NWC and
ATSV!). Using a discount rate of 14%, you should get NPV= $8,638,493.71. Now, just
hit the IRR button to get IRR=27.12%.
(b) To get the best and worst case scenarios, repeat the above calculations (you are using a
spreadsheet, right??) using:
Base Case Worst Case Best Case
Unit sales (new) 55,000 49,500 60,500
Price (new) $700 $630 $770
VC (new) $320 $352 $288
Fixed costs $7,500,000 $8,250,000 $6,750,000
Sales lost (expensive) 13,000 14,300 11,700
Sales gained (cheap) 10,000 9,000 11,000
For the worst case, you should get:
OCF = $932,600
NPV = -$13,898,264
For the best case, you should get
OCF = $17,161,000
NPV = -$34,062,138
(c) For the sensitivity analysis, reset all variables to their base case values. Now, choose a
new value for the price of the new clubs, say $800. Repeating the above calculations for
NPV, you should get
OCF = $9,488,000
NPV = $22,789,900
So, the sensitivity of NPV per dollar change in P is
(22,789,900 - 8,638,494) / (800 - 700) = $141,514.06
Now do the same thing, but using a different value for Q, say, Q=60,000. You should
get
OCF = $7,640,000
NPV = $13,992,304.43
Therefore, the sensitivity of NPV per unit change in Q is
(13,527,161 - 8,638,494) / (60,000 - 55,000) = $977.73