Inse rt 8- Pa ge 1 of 1

C ontact MCE at e hrha rdt@utk.e du for th e Excel file o r for a pi ctu re fi le. A B C D E F G H I
1 Ch 11 Tool Kit 11/15/2004
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3 Chapter 11. Tool Kit for Cash Flow Estimation and Risk Analysis
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6 This w ork sheet contains the model used to an alyze R IC's new project d ecis ion as d es cribed in the text. Th e TA B k ey lab eled
7 "Depreciation " provid es details ab out d ep reciation. In add ition, a model for analyzin g rep lacemen t d ecis ions is p rovided on a
8 separate sheet that can b e access ed by pres sing the TAB k ey labeled "Replacement A nalysis" at the bottom of th e screen.
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10 Incremental Cash Flows
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The relevant cash flows in project an alys is are the p roject's incremen tal cash flow s, defined as th e free cash flows of th e firm with
13 the project min us the free cas h flows of the firm withou t th e project. C onsider the following project to replace an old er machine
14 with a newer and more efficient mach in e. The an nual relevant costs, s avin gs, cash flow s are s hown b elow for the n ew maching an d
15 the old mach in e. Oth er th an the initial cos t, these cash flows are expected to las t for five years .
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17 Table 11-1 Incremental Cash Flows and Project Analysis
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19 New Old Incremental
20 Initial investment $100,000 - $40,000 = $60,000
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22 Annual revenues and costs:
23 Sales revenues $40,000 - $25,000 = $15,000
24 Operating costs -10,000 - -15,000 = 5,000
25 Depreciation -20,000 - -8,000 = -12,000
26 Taxable income $10,000 - $2,000 = $8,000
27 Taxes (40%) $4,000 - $800 = $3,200
28 Net income $6,000 - $1,200 = $4,800
29 Add back depr'n $20,000 - $8,000 = $12,000
30 Net cash flow $26,000 - $9,200 = $16,800
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32 WACC = 10%
33 Life = 5
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35 NPV: -$1,440 $3,685
36 IRR: 9.4% 12.4%
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38 Notes:
39 1. The issue is whether to make a replacement investment. The operation must continue in
40 order to meet obligations to customers. The old equipment is earning positive cash flows, but
41 the return on the value of this equipment--which cannot be sold unless new equipment is
42 purchased--is less than the WACC, so the NPV is negative.
43 2. The new equipment, when treated as a stand-alone investment, has a negative NPV, so it
44 does not appear to be a good investment.
45 3. However, a proper analysis requires determining the firm's incremental cash flows if it
46 makes the new investment--how much new money must it spend (its incremental investment),
47 and how much additional (incremental) cash flow will that investment produce? If the
48 incremental cash flow is more than enough to pay for the incremental investment, then the
49 investment should be made.
50 4. In this case, the NPV of the incremental investment is positive, so the old equipment should
51 be replaced.
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54 Model for Evaluating A New Capital Budgeting Project:
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57 The firs t s ection of this worksh eet contains a model for evalu atin g n ew projects. In Part 1, we first list the k ey in puts u sed in the
58 calculation s. Part 2 goes on to calcu late depreciation schedu les for the b uild in g an d for the equipment. Part 3 then determin es th e
59 after-tax salvage values (i.e., net cash flows ) that will come from dispos in g of the building and the equ ip men t at the end of th e
60 project's life. Part 4 calculates th e estimated cash flow s over each year of the project's life. Part 5 th en u ses th e estimated cash
flow s to estimate the key outpu ts, the p roject's NPV, IRR , MI RR, an d Payback. Fin ally, in Parts 6 and 7, we cons id er the ris kiness
61 of the project b y sh owing how ch anges in the in puts res ult in ch anges in the key outp uts.
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64 Note that all dollars are shown in thousands; this is done for convenience.
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66 Identifying the relevant cash flows
67 For a new project, the incremental cash flows can b e divided into the following categories: initial in ves tmen t
68 outlay, op erating cash flows over the p roject's life, and terminal year cash flows. The d ata us ed in the mod el w ere
69 taken from th e exa mp le in C hapter 11. In ad dition to the inp ut d ata, we hav e in clud ed an excerpt from th e
70 MA CRS Depreciation S ch ed ule for 39-year (b uilding) an d 5-year (equ ip men t) dep reciation, and a table outlining
71 the 'determination of net s alva ge valu es to be incorp orated into ou r cas h flow estimation .
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73 Table 11-4. Analysis of a New (Expansion) Project
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75 Part 1. Input Data (in thousands of dollars)
76 Key Output: NPV = $5,809
77 Building cost (= Depreciable basis) $12,000
78 Equipment cost (= Depreciable basis) $8,000 Market value of building in 2009 $7,500
79 Net Operating WC / Sales 10% Market value of equip. in 2009 $2,000
80 First year sales (in units) 20,000 Tax rate 40%
81 Growth rate in units sold 0.0% WACC 12%
82 Sales price per unit $3.00 Inflation: growth in sales price 2.0%
83 Variable cost per unit $2.10 Inflation: growth in VC per unit 2.0%
84 Fixed costs $8,000 Inflation: growth in fixed costs 1.0%
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86 Part 2. Depre ciation Schedu le a Years Cumulative
87 1 2 3 4 Depr'n
88 Building Depr'n Rate 1.3% 2.6% 2.6% 2.6%
89 Building Depr'n $156 $312 $312 $312 $1,092
90 Ending Book Val: Cost - Cum. Depr'n 11,844 11,532 11,220 $10,908
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92 Equipment Depr'n Rate 20.0% 32.0% 19.0% 12.0%
93 Equipment Depr'n $1,600 $2,560 $1,520 $960 $6,640
94 Ending Book Val: Cost - Cum. Depr'n 6,400 3,840 2,320 $1,360
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96 a
T he depre ci ati on rates are m ultipl ie d by the depr eci able basis ($12,000 for the bui ldi ng and $8, 000 for the equi pme nt) to de term ine the yearl y
depre ci ati on expense . The cor rec t depre ci ati on per centages for the bui ldi ng depe nd upon the month that the bui ldi ng is put in ser vi ce . Be cause
97 thi s analysi s assume s that all cash fl ows occ ur at the end of the year, and to pr event unne ces sar y compl exity, we have r ounde d the depre ci ati on
perc entage s for the buil ding. Se e the Tab name d Depr eci ati on for m or e de tai ls.
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99 Part 3 of Table 11-4. Net Salvage Values in 2009
100 Building Equipment Total
101 Estimated Market Value in 2009 $7,500 $2,000
102 Book Value in 2009b 10,908 1,360
103 Expected Gain or Loss c -3,408 640
104 Taxes paid or tax credit -1,363 256
105 Net cash flow from s alvage d $8,863 $1,744 $10,607
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107 b
Book value equal s depr eci able basis (ini ti al c ost in thi s c ase) m inus ac cum ulated M ACRS depre ci ati on. F or the buil ding, ac cum ulated
108 depre ci ati on equals $1,092, so book value equal s $12, 000 - $1,092 = $10,908. For the equi pme nt, acc umul ate d depr eci ati on equal s $6,640, so book
109 value e qual s $8,000 - $6, 640 = $1,360.
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B uil ding: $7,500 marke t val ue - $10,908 book value = -$3,408 a loss. T his repr ese nts a shortfal l in depre ci ati on take n vers us "true "
112 depre ci ati on, and i t is treated as an ope rating e xpe nse for 2009. Equi pme nt: $2, 000 m ar ket value - $1, 360 book val ue = $640 profit. H ere the
113 depre ci ati on charge excee ds the "true " depr eci ati on, and the di ffe renc e i s c al le d "de prec iation r ecapture ". It i s taxe d as ordi nar y inc ome in
2009. T he ac tual book val ue at the tim e of disposi ti on de pends on the m onth of di spositi on. We have s im pli fi ed the analysis and assume d that
114 the re wil l be a ful l ye ar of depr eci ati on i n 2009.
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116 d
Net c as h flow from salvage equal s salvage (m ar ket) val ue mi nus taxe s. For the bui ldi ng, the loss resul ts i n a tax cre dit, so net sal vage val ue =
117 $7,500 - (-$1,363) = $8, 863.
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119 Part 4 of Table 11-4. Projected Net Cash Years
120 Flows ( Time line of annu al cash flow s) 0 1 2 3 4
121 2005 2006 2007 2008 2009
122 Investment Outlays: Long-Term Assets
123 Building ($12,000)
124 Equipment (8,000)
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126 Operating Cash Flows over the Project's Life
127 Units sold 20,000 20,000 20,000 20,000
128 Sales price $3.00 $3.06 $3.12 $3.18
129 Sales revenue $60,000 $61,200 $62,424 $63,672
130 Variable costs 42,000 42,840 43,697 44,571
131 Fixed operating costs 8,000 8,080 8,161 8,242
132 Depreciation (building) 156 312 312 312
133 Depreciation (equipment) 1,600 2,560 1,520 960
134 Oper. income before taxes (EBIT) 8,244 7,408 8,734 9,587
135 Taxes on operating income (40%) 3,298 2,963 3,494 3,835
136 Net Operating Profit After Taxes (NOPAT) 4,946 4,445 5,241 5,752
137 Add back depreciation 1,756 2,872 1,832 1,272
138 Operating cash flow $6,702 $7,317 $7,073 $7,024
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140 Cash Flows Due to Net Operating Working Capital
141 Net Operating Working Capital (based on sales) $6,000 $6,120 $6,242 $6,367 $0
142 Cash flow due to investment in NOWC ($6,000) ($120) ($122) ($125) $6,367
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144 Salvage Cash Flows: Long-Term Assets
145 Net salvage cash flow: Building $8,863
146 Net salvage cash flow: Equipment 1,744
147 Total salvage cash flows $10,607
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149 Net Cash Flow (Time line of cash flows) ($26,000) $6,582 $7,194 $6,948 $23,999
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151 Part 5 of Table 11-4. Key Output and Appraisal of the Proposed Project
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153 Net Present Value (at 12%) $5,809
154 IRR 20.12%
155 MIRR 17.79% Years
156 0 1 2 3 4
157 Cumulative cash flow for payback (26,000) (19,418) (12,223) (5,275) 18,723
158 Cum. CF > 0, hence Payback Year: 0.00 0.00 0.00 0.00 3.22
159 Payback found with Excel function = 0.00 See note below for an explanation of the Excel calculation.
160 Check: Payback = 3 + 5,275/23,999 = 3.22 Manual calculation for the base case.
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162 The Excel payback calculation is bas ed on the logical IF function. Returns FALS E if th e cu mulative CF is n egative or th e actu al
163 payback if the cumu lative C F is pos itive. Then, w e us e the MIN (minimum) fu nction to fin d first year w hen payback is p ositive.
164 The Min fu nction proced ure is n eces sary for p rojects w ith longer lives, because then values, n ot th e word FALSE , w ould appear in
165 a nu mber of cells. The Min fun ction pick s the smalles t n umber, wh ich is th e payba ck.
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168 Based on th e firm's 12% weighted average cost of capital, th is project has a N PV of $5,809. Since the N PV is p ositive, 'we
169 ten tatively conclu de th at the p roject sh ould be accepted. The I RR and MIRR confirm this decision because b oth exceed the cos t of
170 cap ital. Note, thou gh, that no risk analysis has b een con ducted. It is pos sible that the firm's managers , after ap praising th e
project's risk, might con clud e that its p rojected return is ins ufficient to compens ate for its risk, an d reject it.
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176 Part 6. Evaluating Risk: Sensitivity Analysis
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Risk in capital bu dgeting really means th e probability that the actual ou tcome w ill b e worse th an th e ex pected outcome. For
180 examp le, if there were a high probability that the $5,166 expected NPV as calcu lated above w ill actually turn out to b e negative,
181 then th e project w ould be classified as relatively risky. Th e reason for a worse-than-expected outcome is, typically, becau se s ales
182 were lower than expected, costs were higher than expected, or th e project tu rn ed ou t to have a higher than exp ected in itial cost. In
183 other words, if th e ass umed inp uts turn out to be worse than expected , th en th e outp ut w ill likewise be worse than expected. In
184 Part 6 we u se Excel to examin e the p roject's sens itivity to ch anges in the in put variables.
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186
187 I. Sensitivity of NPV and to Variations in Unit Sales. S ee th e descrip tion at the
188 right for an explanation of
189 h ow to us e data tables .
190 Here we use an Excel "Data Table" to find NPV different unit sales, holding other thing constant.
191
192 % Deviation WACC % Deviation 1st YEAR UNIT SALES
193 from NPV from Units NPV Extra Question: A t w hat
194 Base Case WACC 5,809 Base Case Sold $5,809 1st Year Sales would
195 -30% 8.4% $9,030 -30% 14,000 -$3,628 the project break even
196 -15% 10.2% $7,362 -15% 17,000 $1,091 in the sense that NPV
197 0% 12.0% $5,809 Base Case 0% 20,000 $5,809 = $0?
198 15% 13.8% $4,363 15% 23,000 $10,528
199 30% 15.6% $3,014 30% 26,000 $15,247 An swer: You could plot
200 NPV against Sales and
201 see about where NPV
202 % Deviation VARIABLE COSTS % Deviation GROWTH RATE, UNITS = 0. Alternatively, you
203 from Variable NPV from Growth NPV could use Tools > Goal
204 Base Case Cost $5,809 Base Case Rate % $5,809 Seek as described in
205 -30% $1.47 $29,404 -30% -30% -$4,923 the columns to the right.
206 -15% $1.79 $17,607 -15% -15% -$115 The answer is 16,307
207 0% $2.10 $5,809 Base Case 0% 0% $5,809 units.
208 15% $2.42 -$5,988 15% 15% $12,987
209 30% $2.73 -$17,785 30% 30% $21,556
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211
212 % Deviation SALES PRICE % Deviation FIXED COSTS
213 from Sales NPV from Fixed NPV
214 Base Case Price $5,809 Base Case Costs $5,809
215 -30% $2.10 -$27,223 -30% $5,600 $10,243
216 -15% $2.55 -$10,707 -15% $6,800 $8,026
217 0% $3.00 $5,809 Base Case 0% $8,000 $5,809
218 15% $3.45 $22,326 15% $9,200 $3,593
219 30% $3.90 $38,842 30% $10,400 $1,376
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221 We summarize the data tables, arranged by sensitivity, and graphed the most sensitive items in the following chart:
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224 Figure 11-1. Evaluating Risk: Sensitivity Analysis (Dollars in Thousands)
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227 N PV ($ )
$40,000
228 Sales price
229 $30,000 Varia ble cost
230 Growth rate
231 $20,000 Units sold
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233 $10,000 Fixed cost
234 WACC
235 $0
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237 ($10,000)
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239 ($20,000)
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241 ($30,000)
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-30% -15% 0% 15% 30%
Deviation f rom Bas e- Cas e Value ( %)
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247 Deviation NPV at Different Deviations from Base
248 from Sales Variable Growth Year 1 Fixed
249 Base Case Price Cost/Unit Rate Units Sold Cost WACC
250 -30% ($27,223) $29,404 ($4,923) ($3,628) $10,243 $9,030
251 -15% ($10,707) $17,607 ($115) $1,091 $8,026 $7,362
252 0% $5,809 $5,809 $5,809 $5,809 $5,809 $5,809
253 15% $22,326 ($5,988) $12,987 $10,528 $3,593 $4,363
254 30% $38,842 ($17,785) $21,556 $15,247 $1,376 $3,014
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256 Range 66,064 47,189 26,479 18,875 8,867 6,016
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We s ee from th e tables an d grap h th at N PV is mo st s en sitive to changes in th e sales p rice and variab le costs ,
259 somewhat sensitive to chan ges in first-year sales an d the s ales grow th rate, and not very s en sitive to changes in
260 WACC an d fixed cos ts. Th us, th e real iss ue is our confidence in th e forecasts of the s ales price an d variable costs,
261 as w ell as the first-year sales an d the growth rate in un its s old .
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NPV can ch ange d ramatically if the key in put variables ch ange, but w e do not k now how mu ch the variables are
264 likely to ch ange. For examp le, if w e were b uying comp onents und er a fixed price con tract, then variable costs
265 migh t be locked in an d n ot likely to rise more than say 5%, and we migh t have a firm con tract to sell the p rojected
266 numb er of units at th e indicated p rice per unit. I n that case, the "bad cond itions " w ould not materialize, and a
267 positive NPV w ould be p retty well guaranteed. We go on to look at the p rob abilities of differen t cond itions in Part
268 7.
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270 Part 7. Evaluating Risk: Scenario Analysis
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272 Scen ario an alys is extends ris k analysis in two ways : (1) I t allows us to chan ge more than one variable at a time,
273 hence to s ee th e comb in ed effects of chan ges in several variables on NPV, and (2) It allows us to brin g in the
274 prob abilities of ch anges in th e key varia bles . Part 7 p rovides a s cenario analysis of th e comp uter project. 133,126
275 3,454
276 (36,765)
277 We s aw from th e sens itivity an alys is that the k ey variab les are s ales price, variable costs , unit s ales, an d the u nit
growth rate. Therefore, in our sens itivity an alys is w e hold the other variab les at th eir bas e case levels an d then
278 examine th e situation when the k ey variab les ch ange. We as sume that th e comp any regard s the worst case as one 25,817
279 where each of the three variables is 30% worse than the b ase level, and the b es t case h as each variable 30% better 64,094
280 than base. We also assu me that there is a 25% chance of the best and worst cas es , and a 50% chance of base case 2.48
281 levels .
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283 Table 11-5. Scenario Analysis (Dollars in Thousands) Squared
284 Deviation
285 Sales Unit Variable Growth Times
286 Scenario Probability Price Sales Costs Rate NPV Probability
287
288 Best Case 25% $3.90 26,000 $1.47 30% $146,180 3,366,596,001
289 Base Case 50% $3.00 20,000 $2.10 0% $5,809 295,883,220
290 Worst Case 25% $2.10 14,000 $2.73 -30% ($37,257) 1,135,428,840
291 4797908060
292 Expected NPV = sum, prob times NPV $30,135
293 Standard Deviation = Sq Root of column I sum $69,267
294 Coefficient of Variation = Std Dev / Expected NPV 2.30
295 a. Probability Graph
296 Probability
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298 50%
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301 25%
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304 (37,257) 0 30,135 146,180
305 5,809 NPV ($)
306 Most Likely Mean of distribution
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309 b. Continuous Approximation
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311 Probability Density
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316 (37,257) 0 30,135 146,180
317 NPV ($)
318 5,809
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321
322 An even easier w ay to d o s cenario an alys is is with th e Scenario Man ager. To use this, click on Tools , then S cenarios. You will get
323 the dialog b ox sh own below.
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325 We have already define th e three s cenarios.
326 See below for ins tru ctions on how to create
327 your ow n.
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To s how one of the existing scen arios, s imp ly highlight th at s cenario, click Sh ow, and Excel w ill rep lace all the variables in that
346 scen ario w ith th e desired numb ers. To create a new scenario, s elect the Add b utton sh own above an d you w ill get th e dialog box
347 show n b elow (the s ame steps app ly if you wan t to ed it a s cenario).
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351 Enter a name for the new s cenario (you can p rob ably b e more origin al
352 My new one than w e were). Th e ch anging cells are the on es for wh ich you select
353 different in put values. S in ce there are already some scenarios th at are
354 defined, the dialog box starts w ith th ose cells (corresp onding to u nit s ales,
growth rate, sales p rice, an d unit cos ts). I f you were creating a s cenario
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for the first time, you would have to enter the cells you w ant to change.
356 In th is case, we d on't wan t to add any new ch anging cells to th e ones
357 already specified, bu t in other situations you may w ant to add or remove
358 some of the chan gin g cells that are alread y identified.
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360 After entering a n ame, click OK. (As noted above, you may choose to add
361 or remove chan gin g cells in oth er s itu ation s, bu t n ot here.)
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367 After naming the new scenario and clicking OK, you will get the dialog box shown below.
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380 These values are th e ones for the bas e case. Try typing in some of your ow n choices . We feel op timistic tod ay, s o we w ill typ e in
381 25000 for sales, 10% for growth , 3.50 for price, and 2.0 for cost, as show n below.
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395 Click Add, and it will return the original Scenario Manager dialog box, except you will have a new scenario, as shown below.
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413 To " see" th e the n ew scenario, s imp ly select it and then click on Sh ow. When you close the box, th e new valu es w ill be in the
414 worksh eet cells.
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The Scenario Manager als o has an other powerful feature. Sup pos e you have already defin ed s evera l scen arios, as we have, and
417 you w ould like to see the in puts an d s elected outp uts for the variou s scen arios. To do th is, click on Tool, S cenario s, and you will get
418 the box sh own below (n ote: we h ave deleted th e new scen ario that w e jus t created ).
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Inse rt 8- Pa ge 1 of 1
C ontact MCE at e hrha rdt@utk.e du for th e Excel file o r for a pi ctu re fi le.

A B C D E F G H I
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440 If you click on Summary, you will get the dialog box shown below.
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In our case, we would like to see th e NPV for each scen ario. To do this, enter the
443 app ropriate references in the results cells (D 153), th en click OK. You will get a n ew
444 works heet, called Scen ario S ummary, w ith th e resu lts . To see our result, click on th e
445 Tab S cenario Su mmary.
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448 For those w ho want to u se even more Excel features , you can give names to th e in put
449 and outp ut cells before doing the S ummary. To d o th is , select a particular cell, such as
450 D153 (which has NPV), then pu t your cursor at the top left of th e sh eet on th e Name
box which is to the left of th e formu la bar (w hich s hows the cell reference, s uch as
451 D153, if you h ave not yet named the cell), and type in a n ew n ame, s uch as N PV. Then
452 wh en you run the s ummary, th e summary tab le will have the n ame for the variable,
453 and not its cell reference.
454
455 Adjusting for Risk
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The scenario analysis suggests th at the project could be h igh ly profitab le, bu t also that it is q uite risk y. There is a
458 25% probab ility th at the p roject wou ld res ult in a loss of $32 million. Th ere is also a 25% probability that it could
459 prod uce an NPV of $146 million . The s tandard deviation is high, at $68 million, and th e coefficient of variation is a
460 high 2.17.
461
462 Note that the expected NPV in th e scen ario analysis is much higher than the base case valu e. This occurs becau se
463 und er good cond itions we have high nu mbers multiplied by other high numb ers, giving a very high resu lt.
464
465 This analysis suggest that the project is relatively risky, hence that the base case NPV should be recalculated using a
466 higher WACC. At a WACC of 15% (versus 12% for an average risk project), the base case NPV is: $3,454
467 That number is not very high in relation to the project's cost.
468
469 Changing the WACC would also change the scenario analysis. Here are new figures:
470
471 Probability NPV Dev. Sqd^2
472 Best Case 25% $133,126 2,878,793,515
473 Base Case 50% $3,454 250,056,826
474 Worst Case 25% ($36,765) 979,137,230
475
476 Expected NPV: $25,817
477 Standard Deviation: $64,094
478 Coefficient of Variation: 2.48
479
480 At th is p oin t, the project look s risk y bu t accep table. There is a good chan ce th at it w ill p rodu ce a pos itive N PV, but
481 there is als o a ch ance that the NPV cou ld b e dramatically higher or lower.
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483 If the bad conditions occur, this will hurt but not bankrupt the firm--this is just one project for a large company.
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485 We ind icate at the start that th is p roject's returns w ould b e highly correlated with the firm's oth er p rojects ' returns
486 and als o w ith the gen eral stock market. Thu s, its s tand -alon e risk (wh ich is what we h ave been an alyzing) also
487 reflects its within-firm and market risk. If this were n ot true, then we wou ld n eed to mak e further risk
488 adjus tmen ts.
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491 Finally, recall that we s tated at th e start th at if th e firm und ertakes the p roject, it will b e committed to op erate it for the full 4-year
492 life. Th at is imp ortan t, becau se if it were n ot so committed, then if the bad con ditions occurred du ring the first year of operations ,
493 the firm cou ld s imp ly clos e down op erations. This would cu t its los ses, and th e worse case s cenario wou ld n ot b e nearly a s b ad as
we indicated . Then, the expected N PV wou ld be higher, and the s tandard deviation and coefficien t of variation w ould be lower. We
494 exp lain aban donment options in C hapter 12.
495
496
497 Monte Carlo Simulation
498
499
Mon te Carlo simulation is similar to scen ario analysis in that different values of k ey inpu ts are inp ut. U nlik e scenario analysis,
500
501 Mon te Carlo simulation d raw s the inpu t values from a s pecified probab ility d is tribu tion and th en compu tes the N PV. I t rep eats
this p rocess hun dred , or even thou sand s, of times. It then averages th e NPVs from each rep etition. See the file Ch 11 Tool Kit
502 Simu lation.xls for a detailed example. To us e this spreadsh eet, you will need to in stall the Excel A dd-I n Simtools.xla. See the file
503 Explan ation of S imulation .doc for an explanation of h ow to install th e A dd-I n.
504
505
506 Decision Tree Analysis
507
508 Stage 1: At t=0, the firm has the opportunity to spend $500,000 on a feasibility study.
509
510 Stage 2: At t=1 the firm will learn whether the project ap pears feasibel (there is an 80% chan ce th at th e project w ill b e feas ib le). If
511 it is feasible, the firm can s pend $1,000,000 on a prototype.
512
513 Stage 3: At t=2 th e firm will learn w hether the prototype is su ccessfu l (there is a 60% chance the prototyp e will be s uccess ful). If it
514 is su ccessfu l, th e firm can sp en d $10,000,000 to lau nch the project.
515
516
Stage 4: At t=3 the firm will learn how well the market accep ts th e project. Th ere is a 30% ch ance the p roject will have cas h flow s
517 of $10,000,000 per year for 4 years, a 40% chan ce th e project will h ave cash flow s of $4,000,000 per year for fou r years, an d a 30%
518 ch ance the p roject will have cash flows of -$2,000,000 per year for fou r years. If the p roject is n ot s uccess fu l, the firm can ab andon
519 the project after t=3.
520
521
522 Cost of capital = 11.5%
523
524 Join
525 t=0 t=1 t=2 t=3 t=4 t=5 Probability NPV Prob.xNPV
526
527 $18,000 $18,000 $18,000 0.144 $25,635 $3,691
528 0.3
529 ($10,000) 0.4 $8,000 $8,000 $8,000 0.192 $6,149 $1,181
530 0. 6 0.3
531 ($1,000) ($2,000) Stop 0.144 ($10,883) ($1,567)
532 0.8
533 0. 4
($500) Stop 0.320 ($1,397) ($447)
534 0.2
535 Stop 0.200 ($500) ($100)
536
537 1.000 Expected NPV= $2,758
538
539 s= $10,584
540
541
542
543
544
545
546
547
Base Case

20000
0
3
2.1

Page 3
Best case

26000
0.3
3.9
1.47

Page 4
Worst case

14000
-0.3
2.1
2.73

Page 5
DEPRECIATION

Recovery Allowance Percentage for Personal Property

Class of Investment
Ownership
Year 3-Year 5-Year 7-Year 10-Year

1 33% 20% 14% 10%

2 45% 32% 25% 18%
3 15% 19% 17% 14%
4 7% 12% 13% 12%
5 11% 9% 9%
6 6% 9% 7%
7 9% 7%
8 4% 7%
9 7%
10 6%
11 3%
100% 100% 100% 100%

MACRS for Residential Real Property

Month Property Placed in Service
Year 1 2 3 4 5 6 7 8 9
1 3.485% 3.182% 2.879% 2.576% 2.273% 1.970% 1.667% 1.364% 1.061%
2-27 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636%
28 1.970% 2.273% 2.576% 2.879% 3.182% 3.458% 3.636% 3.636% 3.636%
29 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.152% 0.455% 0.758%
99.99% 99.99% 99.99% 99.99% 99.99% 99.96% 99.99% 99.99% 99.99%

MACRS for Nonresidential Real Property

Month Property Placed in Service
Year 1 2 3 4 5 6 7 8 9
1 2.461% 2.247% 2.033% 1.819% 1.605% 1.391% 1.177% 0.963% 0.749%
2-39 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564%
40 0.107% 0.321% 0.535% 0.749% 0.963% 1.177% 1.391% 1.605% 1.819%
100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Rounded Percentages Used in Analysis

Property Life (in years): 39
Depreciation in Year 1 (assuming half-year convention): 1.30%
Rounded Depreciation in Years 2-39: 2.60%
Depreciation in Year 40: 1.30%
 10 11 12
0.758% 0.455% 0.152%
3.636% 3.636% 3.636%
3.636% 3.636% 3.636%
1.061% 1.364% 1.667%
99.99% 99.99% 99.99%

10 11 12
0.535% 0.321% 0.107%
2.564% 2.564% 2.564%
2.033% 2.247% 2.461%
100.00% 100.00% 100.00%
Scenario Summary
Current Values: Base Case Best case Worst case
Changing Cells:
$D$80 20,000 20,000 26,000 14,000
$D$81 0.0% 0.0% 30.0% -30.0%
$D$82 $3.00 $3.00 $3.90 $2.10
$D$83 $2.10 $2.10 $1.47 $2.73
Result Cells:
$D$153 $5,809 $5,809 $146,180 ($37,257)
Notes: Current Values column represents values of changing cells at
time Scenario Summary Report was created. Changing cells for each
scenario are highlighted in gray.
 A B C D E F G H I J
1 REPLACEMENT ANALYSIS
2
3 In this model, we analyze the issue of whether a piece of equipment should be replaced. While the mechanics
4 of the analysis are somewhat different from the analysis for a new project, the process is similar in that we are
5 concerned with incremental cash flows. In this instance, we will be looking at a case that consists of net salvage value
6 being an intial benefit of the project. This replacement project is deemed by the firm to be of relatively low
7 risk, and is evaluated with a cost of capital of 11.5%
8
9 Input Data
10
11 Cost of the new machine $12,000
12 Reduction in operating costs $5,000
13 New machine's salvage value at end of Year 5 $2,000
14 Old machine's current market value $1,000
15 Old machine's current book value $2,500
16 Increase in Net Operating WC $1,000
17 Tax rate 40%
18 WACC 11.5%
19
20 MACRS 3-year Depreciation Schedule
21
22 Year 1 2 3 4
23 Depr. Rate 33% 45% 15% 7%
24 Depr. Exp. $3,960 $5,400 $1,800 $840
25
26 New depr. $3,960 $5,400 $1,800 $840 0
27 Old depr. $500 $500 $500 $500 $500
28 Net depr. $3,460 $4,900 $1,300 $340 -$500
29
30 Replacement Project Net Cash Flow Schedule
31 Year: 0 1 2 3 4 5
32 Section I. Investment Outlay
33 Cost of new equipment ($12,000)
34 Market value of old equipment 1,000
35 Tax savings on old equipment sale 600
36 Increase in net operating WC (1,000)
37
38
39 Section II. Operating Inflows over the Project's Life
40 Decrease in operating costs $5,000 $5,000 $5,000 $5,000 $5,000
41 Net change in depreciation 3,460 4,900 1,300 340 (500)
42 Net earnings before taxes 1,540 100 3,700 4,660 5,500
43 Taxes 616 40 1,480 1,864 2,200
44 Net operating profit after taxes 924 60 2,220 2,796 3,300
45 Add back depreciation 3,460 4,900 1,300 340 (500)
46 Net operating cash flows $4,384 $4,960 $3,520 $3,136 $2,800
47
48 Section III. Terminal Year Cash Flows
49 Estimated salvage value of new machine $2,000
50 Tax on salvage value (40%) (800)
51 Return of net operating WC 1,000
52 Total termination cash flows $2,200
53
54 Section IV. Net Cash Flow ($11,400) $4,384 $4,960 $3,520 $3,136 $5,000
55 Cumulative cash flows (for payback) ($11,400) ($7,016) ($2,056) $1,464 $4,600 $9,600
56
57 Section V. Capital Budgeting Analysis - - 2.58 3.47 4.92
58 Net Present Value (11.5%) $3,991.08
59 IRR 25.03%
60 MIRR 18.40%
61 Payback (in years) 2.58
62
63 This project carries much less risk than the firm's average project, hence it was only evaluated at 11.5%.
64 The project's NPV is positive; therefore, it should be accepted. A review of the IRR and MIRR also indicate
65 that this project should be accepted because their values are greater than the 11.5% cost of capital. In
66 addition, the payback period for this project is not very long, so if the required payback for this project were
67 3 years then according to the payback criterion this project would also be accepted.