6/14/2003

Chapter 11 Mini Case

Situation

Analysis of New Expansion Project

Part I: Input Data

Equipment cost $200,000Shipping charge $10,000Installation charge $30,000Economic Life 4Salvage Value $25,000 Tax Rate 40%Cost of Capital 10%Units Sold 1250Sales Price Per Unit $200 Incremental Cost Per Unit $100 Inventory/sales 12%Inflation rate 3%

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

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 machinery’s 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 firm’s net operating working capital would have to increase by an amount equal to 12% of sales revenues. The firm’s 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 firm’s other lines by $50,000 per year. Should this be considered in the analysis? If so, how? Answer:See Chapter 11 Mini Case Show

Annual Depreciation Expense

Depreciable Basis = Equipment + freight + installationDepreciable Basis = $240,000

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

d. Construct annual incremental operating cash flow statements.

Annual Operating Cash FlowsYear 1 Year 2 Year 3 Year 4

Units 1250 1250 1250 1250Unit price $200.00 $206.00 $212.18 $218.55 Unit cost $100.00 $103.00 $106.09 $109.27

Sales $250,000 $257,500 $265,225 $273,188 Costs $125,000 $128,750 $132,613 $136,588 Depreciation $79,200 $108,000 $36,000 $16,800 Operating income before taxes (EBIT) $45,800 $20,750 $96,612 $119,800 Taxes (40%) $18,320 $8,300 $38,645 $47,920 Net operating profit after taxes $27,480 $12,450 $57,967 $71,880 Depreciation $79,200 $108,000 $36,000 $16,800 Net Operating CF $106,680 $120,450 $93,967 $88,680

Annual Cash Flows due to Investments in Net Operating Working Capital

Year 0 Year 1 Year 2 Year 3 Year 4Sales $250,000 $257,500 $265,225 $273,188 NOWC (% of sales) $30,000 $30,900 $31,827 $32,783 CF due to investment in NOWC) ($30,000) ($900) ($927) ($956) $32,783

f. Calculate the after-tax salvage cash flow.

After-tax Salvage Value

Salvage Value $25,000 Tax on Salvage Value $10,000 Net Terminal Cash Flow $15,000

c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows?

e. Estimate the required net operating working capital for each year, and the cash flow due to investments in net operating working capital.

Projected Net Cash FlowsYear 0 Year 1 Year 2 Year 3

Investment Outlay: Long Term Assets ($240,000)Operating Cash Flows $106,680 $120,450 $93,967 CF due to investment in NOWC ($30,000) ($900) ($927) ($956)

Salvage Cash FlowsNet Cash Flows ($270,000) $105,780 $119,523 $93,011

NPV $88,030 IRR 23.9%

$358,030 $524,191 Years

Find MIRR 0 1 2 3Net Cash Flows ($270,000) $105,780 $119,523 $93,011

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 Years0 1 2 3

Cumulative Cash Flow for Payback ($270,000) ($164,220) ($44,697) $48,314 Cum. CF > 0, hence Payback Year: 0 0 0 1Payback found with Excel function = 0 0 0 2.5

Payback = 2.5

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

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.

Evaluating Risk: Sensitivity Analysis

Sensitivity of NPV and to Variations in Unit Sales.

We summarize the data tables, arranged by sensitivity, and graphed the most sensitive items in the following chart:

% Deviation WACC % Deviation 1st YEAR UNIT SALES % Deviation SALVAGEfrom NPV from Units NPV from Variable

Base Case WACC 88,030 Base Case Sold $88,030 Base Case Cost-30% 7.0% $113,288 -30% 875 $16,668 -30% $17,500.00-15% 8.5% $100,310 -15% 1,063 $52,348 -15% $21,250.00

0% 10.0% $88,030 0% 1,250 $88,030 0% $25,000.0015% 11.5% $76,398 15% 1,438 $123,711 15% $28,750.0030% 13.0% $65,371 30% 1,625 $159,392 30% $32,500.00

Evaluating Risk: Sensitivity Analysis

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

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.

-40% -30% -20% -10% 0% 10% 20% 30% 40%$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

$180,000

Sensitivity Analysis

WACCUnits SoldSalvage

Deviation from Base-Case Value

NP

V

Deviation NPV Deviation from Base Case -30% $113 from Units -15% $100

Base Case WACC Sold Salvage 0% $88 -30% $113,288 $16,668 $84,956 15% $76 -15% $100,310 $52,348 $86,493 30% $65 0% $88,030 $88,030 $88,030 15% $76,398 $123,711 $89,567 30% $65,371 $159,392 $91,103

Range 47,916 176,060 6,147

(1.) What is scenario analysis?

(2.) What is the worst-case NPV? The best-case NPV?

Evaluating Risk: Scenario Analysis

Scenario Analysis

Squared Deviation Scenario Probability Unit Sales Unit Price NPV times probability

Best Case 25% 1600 $240 $278,965 $7,862,111,358.79

Base Case 50% 1250 $200 $88,030 $92,450,542.34

Worst Case 25% 900 $160 ($48,514) $5,635,612,088.43

Expected NPV = $101,628

(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 project’s 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).

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.

(3.) Use the worst-, most likely, and best-case NPVs and probabilities of occurrence to find the project’s expected NPV, standard deviation, and coefficient of variation.

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 it.

-40% -30% -20% -10% 0% 10% 20% 30% 40%$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

$180,000

Sensitivity Analysis

WACCUnits SoldSalvage

Deviation from Base-Case Value

NP

V

Standard Deviation = $75,684 Coefficient of Variation = Std Dev / Expected NPV = 0.74

Monte Carlo Simulation

Risk Adjusted Cost of Capital

Cost of capital for average projects: 10%Adjustment for risky projects: 3%

Risk adjusted cost of capital: 13%

NPV with risk adjusted cost of capital: $65,371 (See the +30% WACC in the sensitivity analysis above.)

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 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.

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?

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

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

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 machinery’s 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

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 firm’s net operating working capital would have to increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 40 percent, and its

Answer: See Chapter 11 Mini

(2.) Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this be included in the

(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

(4.) Finally, assume that the new product line is expected to decrease sales of the firm’s other lines by $50,000 per year.

d. Construct annual incremental operating cash flow statements.

c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when

e. Estimate the required net operating working capital for each year, and the cash flow due to investments in net operating

Year 4

$88,680 $32,783

$15,000 $136,463

Years

4$136,463 $102,312$144,623

$140,793$524,191

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.

Years4

$184,777 0

0

g. Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR, MIRR, and

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

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

We summarize the data tables, arranged by sensitivity, and graphed the most sensitive items in the following chart:

SALVAGENPV

$88,030$84,956$86,493$88,030$89,567$91,103

Answer: See Chapter 11 Mini Case Show

See Chapter 11 Mini Case

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

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

-40% -30% -20% -10% 0% 10% 20% 30% 40%$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

$180,000

Sensitivity Analysis

WACCUnits SoldSalvage

Deviation from Base-Case Value

NP

V

$17 ###$52 ###$88 ###

$124 ###$159 ###

(1.) What is scenario analysis?

(2.) What is the worst-case NPV? The best-case NPV?

Answer: See Chapter 11 Mini

k. Assume that Sidney Johnson is confident of her estimates of all the variables that affect the project’s 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

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

(3.) Use the worst-, most likely, and best-case NPVs and probabilities of occurrence to find the project’s expected NPV,

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

-40% -30% -20% -10% 0% 10% 20% 30% 40%$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

$180,000

Sensitivity Analysis

WACCUnits SoldSalvage

Deviation from Base-Case Value

NP

V

(See the +30% WACC in the sensitivity analysis above.)

l. Are there problems with scenario analysis? Define simulation analysis, and discuss its principal advantages and

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

for a detailed example. To use this spreadsheet, you will need to install the Excel for an explanation of how to install the Add-In.

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

(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?

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

Base Case

Page 13

1250200

Best Case

Page 14

1600240

Worst Case

Page 15

900160

Scenario Summary

Current Values: Base Case Best Case Worst CaseChanging 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 attime Scenario Summary Report was created. Changing cells for eachscenario are highlighted in gray.