6/14/2003

Chapter 11 Mini Case

Situation Shrieves Casting Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated MBA. The production line would be set up in unused space in Shrieves' main plant. The machinerys invoice price would be approximately $200,000; another $10,000 in shipping charges would be required; and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 4 years, and Shrieves has obtained a special tax ruling which places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $25,000 after 4 years of use. The new line would generate incremental sales of 1,250 units per year for four years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are expected to increase by 3% per year due to inflation. Further, to handle the new line, the firms net operating working capital would have to increase by an amount equal to 12% of sales revenues. The firms tax rate is 40 percent, and its overall weighted average cost of capital is 10 percent. a. Define incremental cash flow. Answer: See Chapter 11 Mini Case Show (1.) Should you subtract interest expense or dividends when calculating project cash flow? Answer: See Chapter 11 Mini Case Show (2.) Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this be included in the analysis? Explain. Answer: See Chapter 11 Mini Case Show (3.) Now assume that the plant space could be leased out to another firm at $25,000 a year. Should this be included in the analysis? If so, how? Answer: See Chapter 11 Mini Case Show (4.) Finally, assume that the new product line is expected to decrease sales of the firms other lines by $50,000 per year. Should this be considered in the analysis? If so, how? Answer:See Chapter 11 Mini Case Show Analysis of New Expansion Project Part I: Input Data Equipment cost Shipping charge Installation charge Economic Life Salvage Value Tax Rate Cost of Capital Units Sold Sales Price Per Unit Incremental Cost Per Unit Inventory/sales Inflation rate $200,000 $10,000 $30,000 4 $25,000 40% 10% 1250 $200 $100 12% 3%

b. Disregard the assumptions in Part a. What is Shrieves' depreciable basis? What are the annual depreciation expenses? Annual Depreciation Expense

Depreciable Basis = Equipment + freight + installation Depreciable Basis = $240,000 Year 1 2 3 4 % 0.33 0.45 0.15 0.07 x Basis $240,000 $240,000 $240,000 $240,000 = Depr. $79,200 $108,000 $36,000 $16,800

c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows? d. Construct annual incremental operating cash flow statements. Annual Operating Cash Flows Units Unit price Unit cost Sales Costs Depreciation Operating income before taxes (EBIT) Taxes (40%) Net operating profit after taxes Depreciation Net Operating CF Year 1 1250 $200.00 $100.00 $250,000 $125,000 $79,200 $45,800 $18,320 $27,480 $79,200 $106,680 Year 2 1250 $206.00 $103.00 $257,500 $128,750 $108,000 $20,750 $8,300 $12,450 $108,000 $120,450 Year 3 1250 $212.18 $106.09 $265,225 $132,613 $36,000 $96,612 $38,645 $57,967 $36,000 $93,967 Year 4 1250 $218.55 $109.27 $273,188 $136,588 $16,800 $119,800 $47,920 $71,880 $16,800 $88,680

e. Estimate the required net operating working capital for each year, and the cash flow due to investments in net operating working capital. Annual Cash Flows due to Investments in Net Operating Working Capital Year 0 Sales NOWC (% of sales) CF due to investment in NOWC) f. Calculate the after-tax salvage cash flow. After-tax Salvage Value Salvage Value Tax on Salvage Value Net Terminal Cash Flow $25,000 $10,000 $15,000 $30,000 ($30,000) Year 1 $250,000 $30,900 ($900) Year 2 $257,500 $31,827 ($927) Year 3 $265,225 $32,783 ($956) Year 4 $273,188 $32,783

g. Calculate the net cash flows for each year. Based on these cash flows, what are the projects NPV, IRR, MIRR, and payback? Do these indicators suggest that the project should be undertaken?

Projected Net Cash Flows

Year 0 Investment Outlay: Long Term Assets Operating Cash Flows CF due to investment in NOWC Salvage Cash Flows Net Cash Flows NPV IRR $88,030 23.9% $358,030 $524,191 Years 1 $105,780 2 $119,523 3 $93,011 ($240,000) ($30,000) ($270,000) $106,680 ($900) $105,780 $120,450 ($927) $119,523 $93,967 ($956) $93,011 Year 1 Year 2 Year 3

Find MIRR
Net Cash Flows

0 ($270,000)

PV=

($270,000)

TV =

To find MIRR, we could now find the discount rate that equates the PV and TV. But it is easier to use the MIRR function. MIRR = 18.0%

Find Payback
0 Cumulative Cash Flow for Payback Cum. CF > 0, hence Payback Year: Payback found with Excel function = Payback = 2.5 ($270,000) FALSE 0 1 ($164,220) FALSE 0

Years 2 ($44,697) FALSE 0

3 $48,314 TRUE 2.5

h. What does the term risk mean in the context of capital budgeting, to what extent can risk be quantified, and when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates? Risk in capital budgeting really means the probability that the actual outcome will be worse than the expected outcome. For example, if there were a high probability that the expected NPV as calculated above will actually turn out to be negative, then the project would be classified as relatively risky. The reason for a worse-than-expected outcome is, typically, because sales were lower than expected, costs were higher than expected, or the project turned out to have a higher than expected initial cost. In other words, if the assumed inputs turn out to be worse than expected then the output will likewise be worse than expected. We use Excel to examine the project's sensitivity to changes in the input variables. i. (1.) What are the three types of risk that are relevant in capital budgeting? Answer: See Chapter 11 Mini Case Show (2.) How is each of these risk types measured, and how do they relate to one another? Answer: See Chapter 11 Mini Case Show

(3.) How is each type of risk used in the capital budgeting process? Answer: See Chapter 11 Mini Case Show

Evaluating Risk: Sensitivity Analysis

Sensitivity of NPV and to Variations in Unit Sales. j. (1.) What is sensitivity analysis? Answer:See Chapter 11 Mini Case Show (2.) Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the project. Assume that each of these variables can vary from its base case, or expected, value by plus and minus 10, 20, and 30 percent. Include a sensitivity diagram, and discuss the results. Here we use an Excel "Data Table" to find NPV different unit sales, holding other thing constant. For example, after inputting the values for WACC in cells B205:B209 and the formula =C105 for NPV in cell C204, select the range B204:C209. Then choose from the menu Data, Table, and enter D31 (which is the input for WACC) as the Column input. This produces the sensitivity analysis for WACC as shown below. We summarize the data tables, arranged by sensitivity, and graphed the most sensitive items in the following chart: % Deviation from Base Case -30% -15% 0% 15% 30% WACC WACC 7.0% 8.5% 10.0% 11.5% 13.0% NPV 88,030 $113,288 $100,310 $88,030 $76,398 $65,371 % Deviation 1st YEAR UNIT SALES % Deviation from Units NPV from Base Case Sold $88,030 Base Case -30% 875 $16,668 -30% -15% 1,063 $52,348 -15% 0% 1,250 $88,030 0% 15% 1,438 $123,711 15% 30% 1,625 $159,392 30% SALVAGE Variable Cost $17,500.00 $21,250.00 $25,000.00 $28,750.00 $32,500.00

Evaluating Risk: Sensitivity Analysis Sensitivity Analysis

$180,000 $160,000 $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 -40%

WACC Units Sold Salvage

NPV

-20%

0%

20%

40%

Deviation from Base-Case Value

Deviation from Base Case -30% -15% NPV Deviation from Base Case Units WACC Sold Salvage $113,288 $16,668 $84,956 $100,310 $52,348 $86,493 -30% -15% 0% 15% 30% $113 $100 $88 $76 $65

0% 15% 30% Range

$88,030 $76,398 $65,371 47,916

$88,030 $123,711 $159,392 176,060

$88,030 $89,567 $91,103 6,147

(3.) What is the primary weakness of sensitivity analysis? What is its primary usefulness? Answer: See Chapter 11 Mini Case Show k. Assume that Sidney Johnson is confident of her estimates of all the variables that affect the projects cash flows except unit sales and sales price: If product acceptance is poor, unit sales would be only 900 units a year and the unit price would only be $160; a strong consumer response would produce sales of 1,600 units and a unit price of $240. Sidney believes that there is a 25 percent chance of poor acceptance, a 25 percent chance of excellent acceptance, and a 50 percent chance of average acceptance (the base case). (1.) What is scenario analysis? Scenario analysis extends risk analysis in two ways: (1) It allows us to change more than one variable at a time, hence to see the combined effects of changes in several variables on NPV, and (2) It allows us to bring in the probabilities of to see the combined effects of changes in several variables on NPV, and (2) It allows us to bring in the probabilities of changes in the key variables. (2.) What is the worst-case NPV? The best-case NPV? (3.) Use the worst-, most likely, and best-case NPVs and probabilities of occurrence to find the projects expected NPV, standard deviation, and coefficient of variation.

Evaluating Risk: Scenario Analysis

We could find the NPV by entering the value of unit sales and price for each scenario and then recording the NPV (this is what we did for the table below). Alternatively, we could use Tools, Scenarios to define the inputs for each scenario, which we did. In fact, you could even use Tools, Scenarios, and then click the Summary button on the dialog box, and it will automatically create a table similar to the one below. This is a powerful feature of Excel, and we encourage you to explore

Scenario Analysis
Squared Deviation times probability

Scenario Best Case Base Case Worst Case

Probability 25% 50% 25%

Unit Sales 1600 1250 900

Unit Price $240 $200 $160

NPV

$278,965 $7,862,111,358.79 $88,030 $92,450,542.34 ($48,514) $5,635,612,088.43 $101,628 $75,684 0.74

Expected NPV = Standard Deviation = Coefficient of Variation = Std Dev / Expected NPV =

l. Are there problems with scenario analysis? Define simulation analysis, and discuss its principal advantages and disadvantages. Answer: See Chapter 11 Mini Case Show

Monte Carlo Simulation

Monte Carlo simulation is similar to scenario analysis in that different values of key inputs are input. Unlike scenario analysis, Monte Carlo simulation draws the input values from a specified probability distribution and then computes the NPV. It repeats this process hundred, or even thousands, of times. It then averages the NPVs from each repetition. See the file FM11 Ch 11 Mini Case Simulation.xls for a detailed example. To use this spreadsheet, you will need to install the Excel Add-In Simtools.xla . See the file Explanation of Simulation.doc for an explanation of how to install the Add-In.

Risk Adjusted Cost of Capital

m. (1.) Assume that Shrieves' average project has a coefficient of variation in the range of 0.2 0.4. Would the new furniture line be classified as high risk, average risk, or low risk? What type of risk is being measured here? Answer: See Chapter 11 Mini Case Show (2.) Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk. This project is riskier than the firm's average project, so he adds 3 points. Should the new furniture line be accepted? Cost of capital for average projects: Adjustment for risky projects: Risk adjusted cost of capital: NPV with risk adjusted cost of capital: 10% 3% 13% $65,371 (See the +30% WACC in the sensitivity analysis above.)

(3.) Are there any subjective risk factors that should be considered before the final decision is made? Answer: See Chapter 11 Mini Case Show

dgeting analysis is being unused space in Shrieves' shipping charges would be economic life of 4 years, lass. The machinery is

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es by $50,000 per year.

al depreciation expenses?

include inflation when

estments in net operating

PV, IRR, MIRR, and

Year 4

$88,680 $32,783 $15,000 $136,463

4 $136,463 $102,312 $144,623 $140,793 $524,191

o use the MIRR function.

4 $184,777 FALSE 0

quantified, and when risk ubjective, judgmental

the expected outcome. For urn out to be negative, come is, typically, because a higher than expected put will likewise be worse

er 11 Mini Case Show

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oject. Assume that each of rcent. Include a

For example, after elect the range C) as the Column input.

e following chart: SALVAGE NPV $88,030 $84,956 $86,493 $88,030 $89,567 $91,103

WACC Units Sold Salvage

$17 $52 $88 $124 $159

## ## ## ## ##

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Scenario Summary
Current Values: Base Case Best Case Worst Case

Changing Cells: $D$31 1250 1250 1600 900 $D$32 $200 $200 $240 $160 Result Cells: $C$109 $88,030 $88,030 $278,965 ($48,514) $C$110 23.9% 23.9% 48.3% 1.0% 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.