4/11/2010

Chapter 11. Solution to Ch 11-18 Build a Model

Webmasters.com has developed a powerful new server that would be used for corporations Internet activities. It would cost $10 million at Year 0 to buy the equipment necessary to manufacture the server. The project would require net working capital at the beginning of each year in an amount equal to 10% of the year's projected sales; for example, NWC 0 = 10%(Sales1). The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 3%. The companys nonvariable costs would be $1 million at Year 1 and would increase with inflation. The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. Also, the project's returns are expected to be highly correlated with returns on the firm's other assets. The firm believes it could sell 1,000 units per year. The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of the equipment at the end of the projects 4-year life is $500,000. Webmasters federal-plus-state tax rate is 40%. Its cost of capital is 10% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 and 1.2. Lowrisk projects are evaluated with a WACC of 8%, and high-risk projects at 13%. a. Develop a spreadsheet model, and use it to find the projects NPV, IRR, and payback. Key Output: NPV = IRR = MIRR = Market value of equipment at Year 4 Tax rate WACC Inflation $3,463 21.1% 17.0% $500 40% 10% 3.0%

Part 1. Input Data (in thousands of dollars) Equipment cost Net WC/Sales First year sales (in units) Sales price per unit Variable cost per unit Nonvariable costs $10,000 10% 1,000 $24.00 $17.50 $1,000

Part 2. Depreciation and Amortization Schedule Year Initial Cost Equipment Depr'n Rate Equipment Depr'n, Dollars Ending Bk Val: Cost Accum Dep'rn Part 3. Net Salvage Values, in Year 4 Estimated Market Value in Year 4 Book Value in Year 4 Expected Gain or Loss Taxes paid or tax credit Net cash flow from salvage

1 20.0% $2,000

Years 2 32.0% $3,200

3 19.0% $1,900

4 12.0% $1,200 $1,700

Accum'd Depr'n

$8,300

10,000 Equipment $500 1,700 -1,200 -480 $980

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Part 4. Projected Net Cash Flows (Time line of Annual Cash Flows) Years 0 Investment Outlays at Time Zero: Equipment ($10,000) Operating Cash Flows over the Project's Life: Units sold Sales price Variable costs Sales revenue Variable costs Nonvariable operating costs Depreciation (equipment) Oper. income before taxes (EBIT) Taxes on operating income (40%) After-tax operating income Add back depreciation Operating cash flow Terminal Year Cash Flows: Required level of net working capital Required investment in NWC Terminal Year Cash Flows: Net salvage value Net Cash Flow (Time line of cash flows) Part 5. Key Output: Appraisal of the Proposed Project Net Present Value (at 10%) IRR MIRR Payback (See calculation below) $3,463 21.09% 16.99% 2.90 0 (12,400) (12,400) ($12,400)

1,000 $24.00 $17.50 $24,000 17,500 1,000 2,000 $3,500 1,400 $2,100 2,000 $4,100

1,000 $24.72 $18.03 $24,720 18,025 1,030 3,200 $2,465 986 $1,479 3,200 $4,679

1,000 $25.46 $18.57 $25,462 18,566 1,061 1,900 $3,935 1,574 $2,361 1,900 $4,261

1,000 $26.23 $19.12 $26,225 19,123 1,093 1,200 $4,810 1,924 $2,886 1,200 $4,086

$2,400 ($2,400)

$2,472 ($72)

$2,546 ($74)

$2,623 ($76)

$0 $2,623

980 $4,028 $4,605 $4,185 $7,689

3 1 4,028 (8,372) 1.00 2 4,605 (3,767) 1.00 3 4,185 417 0.90 4 7,689 8,106 0.00

Data for Payback Years Net cash flow Cumulative CF Part of year required for payback

b. Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and number of units sold. Set these variables values at 10% and 20% above and below their base-case values. Include a graph in your analysis.

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Part 6. Evaluating Risk: Sensitivity Analysis I. Sensitivity of NPV to Changes in Inputs. Here we use Excel "Data Tables" to find NPVs at different unit sales, WACC, variable costs, sales price and nonvariable costs--changing one variable at a time, holding other things constant. % Deviation 1st YEAR UNIT SALES from Units NPV Base Case Sold $3,463 -20% 800 1,044 -10% 900 2,254 0% 1,000 3,463 10% 1,100 4,672 20% 1,200 5,881 % Deviation from Base Case -20% -10% 0% 10% 20% VARIABLE COST Variable NPV Costs $3,463 $14.00 10,401 15.75 6,932 17.50 3,463 19.25 (6) 21.00 (3,475) % Deviation from Base Case -20% -10% 0% 10% 20% WACC WACC 8.0% 9.0% 10.0% 11.0% 12.0% NPV $3,463 4,251 3,849 3,463 3,091 2,732

% Deviation NONVARIABLE COST from Fixed NPV Base Case Costs $3,463 -20% $800 3,859 -10% 900 3,661 0% 1,000 3,463 10% 1,100 3,265 20% 1,200 3,066

% Deviation SALES PRICE from Sales NPV Base Case Price $3,463 -20% $19.20 (5,893) -10% 21.60 (1,215) 0% 24.00 3,463 10% 26.40 8,141 20% 28.80 12,819 Note about data tables. The data in the column input should NOT be input using a cell reference to the column input cell. For example, the base case number of units sold in Cell B105 should be the number 1000; you should NOT have the formula =D29 in that cell. This is because you'll use D29 as the column input cell in the data table and if Excel tries to iteratively replace Cell D29 with the formula =D29 rather than a series of numbers, Excel will calculate the wrong answer. Unfortunately, Excel won't tell you that there is a problem, so you'll just get the wrong values for the data table!

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Sensitivity Analysis
NPV ($) 11,000 9,000 7,000 5,000 3,000 1,000 (1,000) -20% (3,000) (5,000) (7,000)
Sales Price

Units Sold Nonvariable Cost WACC

-10%

0%

10%
Variable Cost

20%

Percentage Deviation from Base

Deviation from Base Case -20% -10% 0% 10% 20% Range

NPV at Different Deviations from Base Sales Variable Nonvariable Price Cost/Unit Units Sold Cost ($5,893) $10,401 $1,044 $3,859 (1,215) 6,932 2,254 3,661 3,463 3,463 3,463 3,463 8,141 (6) 4,672 3,265 12,819 (3,475) 5,881 3,066 $18,712 $13,876 $4,837 $793

WACC $4,251 3,849 3,463 3,091 2,732 $1,519

c. Now conduct a scenario analysis. Assume that there is a 25% probability that best-case conditions, with each of the variables discussed in Part b being 20% better than its base-case value, will occur. There is a 25% probability of worst-case conditions, with the variables 20% worse than base, and a 50% probability of base-case conditions.

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Part 7. Evaluating Risk: Scenario Analysis Sales Price $28.80 $24.00 $19.20 Unit Sales 1,200 1,000 800 Variable Costs $14.00 $17.50 $21.00

Scenario Best Case Base Case Worst Case

Probability 25% 50% 25%

NPV $25,434 $3,463 ($11,991) $5,092 $53,177 10.44

Squared Deviation Times Probability 1655161055 5309943 1167318095

Expected NPV = sum, prob times NPV Standard Deviation = Sq Root of column H sum Coefficient of Variation = Std Dev / Expected NPV

d. If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and payback. CV range of firm's average-risk project: Low-risk WACC = 8% WACC = 10% High-risk WACC = 13% Risk-adjusted WACC = Risk adjusted NPV = IRR = Payback = 13% $2,387 21.09% 2.90 0.8 to 1.2

e. On the basis of information in the problem, would you recommend that the project be accepted? At this point, the project looks risky but acceptable. There is a good chance that it will produce a positive NPV, but there is also a chance that the NPV could be quite low. The problem gave no information about the size of the project relative to the total corporation. If the company were quite large, and this were but one of many projects, and if the projects were independent of one another, then it should be accepted. However, if the firm were relatively small, and this project under bad conditions could bankrupt the company, then the decision is not clear. If management is highly risk averse, they might turn it down. However, well-diversified investors would probably prefer to see it accepted. So, to maximize the stock price, it should be accepted. We indicate in the problem that this project's returns will tend to be highly correlated with the firm's other projects' returns. Thus, its stand-alone risk (which is what we have been analyzing) also reflects its within-firm risk. If this were not true, then we would need to make further risk adjustments.

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Scenario Summary
Current Values: Base Best Worst

Changing Cells: $D$29 1,000 1,000 1,200 800 $D$30 $24.00 $24.00 $28.80 $19.20 $D$31 $17.50 $17.50 $14.00 $21.00 Result Cells: $D$79 $3,463 $3,463 $25,434 ($11,991) $D$80 21.09% 21.09% 76.96% #NUM! $D$81 16.99% 16.99% 43.42% -41.39% 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.