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12 Chapter model

4/20/2012 6:49


Chapter 12. Cash Flow Estimation and Risk Analysis

This worksheet contains a model to analyze BQC's new computer control project. Models for analyzing real options, replacement decisions, projects with unequal lives, and bond refunding are also provided on separate worksheets. Access those models by pressing the appropriate TAB key at the bottom of the screen. Later in the model, we extend the analysis done here to deal with real options and other topics (see tabs below).


The main model, on this tab, evaluates the computer project. Part 1 lists the key inputs used in the calculations. Part 2 develops the depreciation data. Part 3 estimates the cash flows from disposing of the building and the equipment at the end of the project's life. Part 4 calculates the cash flows during each year of the project's operating life. Part 5 then uses the estimated cash flows to estimate the key outputs and shows them as a time line which is used to calculate the NPV, IRR, MIRR, and Payback. Finally, in Parts 6 and 7, we consider the riskiness of the project by showing how changes in the inputs would result in changes in the key outputs. All dollars are shown in thousands. Data are taken from the example in Chapter 12. The model also does a scenario analysis where three variables--unit sales, the sale price, and the VC%--are changed. Other variables are held constant at their base case levels. The analysis can be done manually by inserting data for the various scenarios into the input data cells. However, we also set up Scenarios using the Scenario Manager tool, which is described in the Tutorial. This tool can be used to move to the different scenarios, but it is not necessary.

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Table 12-1. Analysis of a New (Expansion) Project (Thousands of Dollars) Part 1. Input Data
Building cost (= Depr'n basis) Equipment cost (= Depr'n basis) Net Operating WC First year sales (in units) Growth rate in units sold Sales price per unit Variable cost per unit Fixed costs $12,000 $8,000 $6,000 20,000 0.0% $3.00 $2.10 $8,000 Market value of building in 2010 Market value of equip. in 2010 Tax rate WACC Inflation: growth in sales price Inflation: growth in VC per unit Inflation: growth in fixed costs Years 2008 2.6% $312 $468 $11,532 32.0% $2,560 $4,160 $3,840 $7,500 $2,000 40% 12% 0.0% 0.0% 0.0%

Part 2. Depreciation Schedule a

Building Depr'n Rate Building Depr'n Expense Cumulative Depr'n Ending Book Value: Cost - Cum. Depr'n Equipment Depr'n Rate Equipment Depr'n Expense Cumulative Depr'n Ending Book Value: Cost - Cum. Depr'n

2007 1.3% $156 $156 $11,844 20.0% $1,600 $1,600 $6,400

2009 2.6% $312 $780 $11,220 19.0% $1,520 $5,680 $2,320

2010 2.6% $312 $1,092 $10,908 12.0% $960 $6,640 $1,360

The indicated percentages are multiplied by the depreciable basis ($12,000 for the building and $8,000 for the equipment) to determine the depreciation expense for the year.

Part 3. Salvage Value Calculations

Estimated Market Value in 2010 Book Value in 2010b Expected Gain or Lossc Tax liability or credit Net cash flow from salvaged

Building Equipment $7,500 $2,000 10,908 1,360 -3,408 640 -1,363 256 $8,863 $1,744



Book value equals depreciable basis (initial cost in this case) minus accumulated MACRS depreciation. For the building, accumulated depreciation is $1,092, so book value is $12,000 - $1,092 = $10,908. For the equipment, accumulated depreciation is $6,640, so book value is $8,000 - $6,640 = $1,360. Building: $7,500 market value - $10,908 book value = -$3,408, a loss. Thus there's a shortfall in depreciation taken versus "true" depreciation, and it is treated as an operating expense for 2010. Equipment: $2,000 market value - $1,360 book value = $640 profit. Here the depreciation charge exceeds the "true" depreciation, and the difference is called "depreciation recapture". It is taxed as ordinary income in 2010. Net cash flow from salvage equals salvage (market) value minus taxes. For the building, the loss results in a tax credit, so net salvage value = $7,500 - (-$1,363) = $8,863.

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Part 4. Projected Cash Flows

0 2006 Investment Outlays at Time Zero Building Equipment Increase in Net Working Capital Operating Cash Flows over the Project's Life Units sold Sales price Sales revenue Variable costs Fixed operating costs Depreciation (building) Depreciation (equipment) EBIT Taxes on operating income (40%) NOPAT Add back depreciation Operating cash flow Terminal Year Cash Flows Return of net operating working capitale Net salvage value Total termination cash flows Projected Cash Flows (CF time line)

1 2007

Years 2 2008

3 2009

4 2010

-$12,000 -8,000 -6,000

20,000 $3.00 $60,000 42,000 8,000 156 1,600 $8,244 3,298 $4,946 1,756 $6,702

20,000 $3.00 $60,000 42,000 8,000 312 2,560 $7,128 2,851 $4,277 2,872 $7,149

20,000 $3.00 $60,000 42,000 8,000 312 1,520 $8,168 3,267 $4,901 1,832 $6,733

20,000 $3.00 $60,000 42,000 8,000 312 960 $8,728 3,491 $5,237 1,272 $6,509

$6,000 10,607 $16,607 -$26,000 $6,702 $7,149 $6,733 $23,116

Net working capital will be recovered at the end of the project's operating life, at year-end 2010, as inventories are sold off and receivables are collected.

Part 5. Appraisal of the Proposed Project

NPV (at 12%) IRR MIRR Payback (Excel function)
Manual Payback = 3 + 5,416/23,116=

$5,166 19.33% 17.19% 3.23 3.23 0 -26,000 1 -19,298 Years 2 -12,149 3 -5,416 4 17,700 3.23

Cumulative cash flow for payback:

Payback: We first calculate the cumulative CFs. The payback period is the year before the cumulative CF turns positive, which in this case is 3, plus a fraction equal to (unrecovered after Year 3) / (CF in Year 4) = 0.23, so the payback is 3.23 years. We also used an Excel Logical Function to automate payback calculation. This is useful if you plan to do sensitivity analysis or want to analyze a lot of projects. See the Excel tutorial on the Web site for an explanation of the payback function we developed.

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Based on the 12% WACC, the project's NPV is $5,166. Since the NPV is positive and both the IRR and MIRR exceed the WACC, we tentatively conclude that the project should be accepted. Note, though, that no risk analysis has been conducted. It is possible that BQC's managers, after appraising the project's risk, might conclude that its projected return is insufficient to compensate for the risk and thus reject it. Also, senior managers might conclude that the project is inconsistent with the firm's long-run strategic plan. Finally, bringing in real options, which we discuss in the next tab, might change the project's risk/return profile.

MEASURING STAND-ALONE RISK (Section 12.5) Part 6. Evaluating Risk: Sensitivity Analysis
Risk in capital budgeting essentially means the probability that the actual outcome will be much worse than the expected outcome. For example, if there were a high probability that the $5,166 expected NPV as calculated above will turn out to be quite negative, then the project would be classified as relatively risky. The reason for a worse-than-expected outcome is, typically, that sales are lower than expected, costs are higher than expected, or the project turns 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. The model analyzes the sensitivity of the project's NPV to variations in WACC, unit sales, variable costs, growth rates, sales price, and fixed costs. We developed the following Excel Data Tables to find NPV at different levels for each variable, holding other things constant.

% Deviation

WACC WACC 8.4% 10.2% 12.0% 13.8% 15.6%

% Deviation 1st YEAR UNIT SALES

from Base Case -30% -15% 0% 15% 30%

NPV from 5,166 Base Case $8,294 -30% $6,674 -15% $5,166 Base Case 0% $3,761 15% $2,450 30%

% Deviation

VARIABLE COSTS % Deviation from Variable NPV from Base Case Cost $5,166 Base Case -30% $1.47 $28,129 -30% -15% $1.79 $16,647 -15% 0% $2.10 $5,166 Base Case 0% 15% $2.42 -$6,315 15% 30% $2.73 -$17,796 30%

NPV Extra Question: At what $5,166 1st Year Sales would -$4,675 the project break even $246 in the sense that NPV $5,166 = $0? $10,087 $15,007 Answer: You could plot NPV against Sales and see about where NPV GROWTH RATE, UNITS = 0. Alternatively, you Growth NPV could use Tools > Goal Rate % $5,166 Seek as described in -30% -$5,847 the columns to the right. -15% -$907 The answer is 16,850 0% $5,166 units. 15% $12,512 30% $21,269 Units Sold 14,000 17,000 20,000 23,000 26,000

% Deviation

from Base Case -30% -15% 0% 15% 30%

SALES PRICE % Deviation Sales NPV from Price $5,166 Base Case $2.10 -$27,637 -30% $2.55 -$11,236 -15% $3.00 $5,166 Base Case 0% $3.45 $21,568 15% $3.90 $37,970 30%

FIXED COSTS Fixed NPV Costs $5,166 $5,600 $9,540 $6,800 $7,353 $8,000 $5,166 $9,200 $2,979 $10,400 $792

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We summarize the data tables, arranged by sensitivity, and graph the results in the following chart:

Figure 12-1. Evaluating Risk: Sensitivity Analysis (Dollars in Thousands)

Deviation from Base -30% -15% 0% 15% 30% Range NPV at Different Deviations from Base Sales Variable Sales Year 1 Fixed Price Cost/Unit Growth Units Sold Cost -$27,637 $28,129 -$5,847 -$4,675 $9,540 -11,236 16,647 -907 246 7,353 5,166 5,166 5,166 5,166 5,166 21,568 -6,315 12,512 10,087 2,979 37,970 -17,796 21,269 15,007 792 $65,607 $45,925 $27,116 $19,682 $8,748

WACC $8,294 6,674 5,166 3,761 2,450 $5,844

Sensitivity Analysis Graph

40,000 Sales price 30,000 20,000 10,000 Sales growth


Unit sales WACC Fixed cost

0 -10,000 -20,000 -30,000 -30%

Variable cost






We see from the graph and the tables that NPV is quite sensitive to changes in the sales price and variable costs, somewhat sensitive to changes in first-year sales and the sales growth rate, and not very sensitive to changes in WACC and fixed costs. Thus, the key issue is our confidence in the forecasts of the sales price and variable costs.

Note too that NPV can change dramatically if the key input variables change, but we do not know how much the variables are likely to change. For example, if we were buying components under a fixed price contract, then variable costs might be locked in and not likely to rise by more than say 5%, and we might have a firm contract to sell the projected number of units at the indicated price per unit. In that case, the "bad conditions" would not materialize, and a positive NPV would be pretty well guaranteed. We bring probabilities of different conditions into the analysis in Part 7.

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Part 7. Evaluating Risk: 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, and (2) It allows us to bring in the probabilities of changes in the key variables. In this section we do a scenario analysis for the computer project. We saw from the sensitivity analysis that the key variables are sales price, variable costs, unit sales, and the unit growth rate. Therefore, in our sensitivity analysis we hold the other variables at their base case levels and then examine the situation when the key variables change. We assume that the company regards the worst case as one where each of the three variables is 30% worse than the base level, and in the best case each variable is 30% better than base. We also assume that there is a 25% chance of the best and worst cases, and a 50% chance of base case levels.

Figure 12-2. Scenario Analysis (Dollars in Thousands)

Good Base Bad

Units Price VC

26,000 $3.90 $1.47

20,000 $3.00 $2.10

14,000 $2.10 $2.73

Change the inputs to these values get the NPVs for the different scenarios. When finished, return to base case variable levels. We also used Scenario Manager as described in the Tutorial, but this step is not necessary. Predicted Cash Flow for Each Year 1 2 3 33,810 34,257 33,841 6,702 7,149 6,733 -9,390 -8,943 -9,359 NPV @ 12% $87,503 $5,166 -$43,711 $13,531 $47,139 3.48

Scenario Cash Flows:

Best Case Base Worst Case

Prob: 25% 50% 25%

0 -26,000 -26,000 -26,000

4 50,224 23,116 7,024

Expected NPV Standard deviation Coefficient of Variation a. Probability Graph Probability 50%



0 $5,166 Most Likely NPV

$87,503 NPV ($) $13,531 Expected NPV

b. Continuous Approximation Probability Density


0 $5,166


$87,503 NPV ($)

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The scenario analysis suggests that the project would be highly profitable, but it is quite risky. There is a 25% probability that the project would result in a loss of $43.7 million. There is also a 25% probability that it could produce an NPV of $87.5 million. The standard deviation is high, at $47.1 million, and the coefficient of variation is a high 3.48. Note that the expected NPV in the scenario analysis is much higher than the base case value. This occurs because under good conditions we have high numbers multiplied by other high numbers, giving a very high result. This analysis suggest that the project is relatively risky, thus the base case NPV should be recalculated using a higher WACC. At a WACC of 15%, the base case NPV is shown below. That number is not very high in relation to the project's cost. NPV @ 15% = $2,877

Changing the WACC would also change the scenario analysis. Here are new figures: Prob. 25% 50% 25%
NPV @ 15%

Best Case Base Case Worst Case

$80,270 $2,877 ($43,065) $10,740 $44,309 4.13

Expected NPV: Standard Deviation: Coefficient of Variation:

Based on the analysis to 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 dramatically higher or lower. If the bad conditions occur, this will hurt but not bankrupt the firm--this is just one project for a large company. We also noted that this project's returns would be highly correlated with the firm's other projects and also with the general stock market. Thus, its stand-alone risk (which is what we have been analyzing) also reflects its within-firm and market risk. If this were not true, then we would need to consider risk further. Finally, recall that we stated at the start that if the firm undertakes the project, it will be committed to operate it for the full 4-year life. That is important, because if it were not so committed, then if the bad conditions occurred during the first year of operations, the firm could simply close down operations. This would cut its losses, and the worse case scenario would not be nearly as bad as we indicated. Then, the expected NPV would be higher, and the standard deviation and coefficient of variation would be lower. We extend the model to deal with abandonment and other real options in the next tab, "Real Options".

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In this model we examine four types of real options: abandonment, timing, growth, and flexibility.

ABANDONMENT (Section 12.8)

We use BQC's computer control project as discussed in Section 12.2 to illustrate abandonment. Recall that due to labor contracts and other constraints, that originally the project could not be terminated before the end of its 4-year life. We show below decision trees for three scenarios under the "Can't Abandon" and "Can Abandon" cases. Cash flows are taken from the Chapter 12 model (previous tab), where they were calculated. In Column B, we show the probabilities for each scenario. Next, in Columns C through G, we show the annual cash flows under each scenario. Column H shows the NPV under each scenario at a 12% risk-adjusted cost of capital. The probability times the NPV for each branch of the tree is calculated in cell H21 (cell H32 if abandoned); it is the expected NPV. Then, cell H22 (cell H33 if abandoned) gives the standard deviation, and the coefficient of variation is shown in cell H23 (cell H34 if abandoned). As noted, the project is risky, but it has a high expected NPV. It would probably be accepted, but if things turn out badly, this would hurt the company rather badly.

Table 12-2. Decision Trees Without and With the Abandonment Option (Dollars in Thousands) Situation 1. Cannot Abandon.
Prob: 25% 50% 25% 12% Predicted Cash Flow for Each Year 0 1 2 3 4 -26,000 33,810 34,257 33,841 50,224 -26,000 6,702 7,149 6,733 23,116 -26,000 -9,390 -8,943 -9,359 7,024 Expected NPV Standard Deviation (SD) Coefficient of Variation (CV) = Std Dev/Expected NPV 12% End of Period Cash Flows: 1 2 3 33,810 34,257 33,841 6,702 7,149 6,733
-$9,390 -$9,390 -$8,943 $18,244 -$9,359 $0


Best Case Base

Worst Case

NPV @ 12% $87,503 $5,166 -$43,711 $13,531 $47,139 3.48

Situation 2. Can Abandon.

Prob. 25% 50% 0% 25% 0 -26,000 -26,000
-$26,000 -$26,000


Best Case Base Worst #1 Worst #2

4 50,224 23,116
$7,024 $0

Expected NPV Standard Deviation (SD) Coefficient of Variation (CV) = Std Dev/Expected NPV Value of the Real Option to Abandon Expected NPV with Abandonment

NPV @ 12% $87,503 $5,166 -$43,711 Disregard -$19,840 Choose $19,499 $40,567 2.08


Expected NPV without Abandonment Difference = Value of the Option

$13,531 $5,968

The possiblity of abandonment raises the expected NPV because some negative CFs will not occur. The standard deviation also declines. Both of these changes cause the CV to decline. The project's CV ends up close to 2.0, which is the average for BQC's projects, which in turn suggests that it is appropriate to evaluate the project using the 12% WACC. Finally, note that the difference between the expected NPV with and without abandonment represents the value of the abandonment option. It often turns out that without abandonment, the bad case outcome is so bad that it causes the expected NPV to be negative, hence causes the project to look unacceptable. However, when abandonment possibilities are factored in, the worse case outcome is not nearly as bad, and the expected NPV becomes positive. Clearly, abandonment option possibilities must be considered to obtain valid assessments for different projects.

Investment Timing Options (The analysis in the remainder of this tab deals with timing,
growth, and flexibility options as discussed in Web Appendix 12G) An "investment timing option" involves the decision of when to commit to a project. If the project can be delayed, then the expected NPV might be increased. Perhaps new technology will become available to cut costs, or perhaps the firm can get a better idea of the size of the market before committing to the project. In any event, timing options can be valuable.

Problem: Assume that Williams Inc. is considering a project that requires an initial investment of $5 million in 2007. The project is expected to generate a constant stream of cash flows for the next 4 years. However, the size of the cash flows would depend on future market conditions. If the product were well received, then sales would be strong in the coming year and would remain strong for the duration of the project's life. However, if the project performs poorly in the coming year, cash flows would remain weak into the future. Under good conditions, the annual net cash flow would be $2.5 million at the end of each of the next 4 years. Under bad conditions, cash flows would be $1.2 million per year. The probabilities of strong and weak demand are both 50%, and the firm's cost of capital is 10%. The decision tree is shown below. (All dollar figures are in millions.) Proceed Immediately, i.e., Invest Now Prob. 50% 50% 2007 -$5.0 -$5.0 2008 $2.5 $1.2 End of Period: 2009 2010 $2.5 $2.5 $1.2 $1.2 2011 $2.5 $1.2

Good Conditions Bad Conditions

Expected NPV = sum, prob. times NPV Standard Deviation Coefficient of Variation = Std Dev / Expected NPV

With an expected NPV of $.864 million, the project appears to be profitable, but it does have a high SD and CV, hence it is risky. That risk might warrant the use of a higher WACC, which might make the NPV turn negative. However, note that the project's risk arises because we do not know how demand will turn out next year. If we could wait until we had more information about demand, the project's risk could be reduced. The expected NPV would be either high, in which case we would accept the project, or low, in which case we would reject it. How should the project be analyzed under this condition? Problem: Suppose Williams can wait until next year to make the decision. If it waits, it will have more information about market conditions. Whereas today it can only guess what demand will be, if it waits a year it will know precisely what conditions actually are. All other aspects of the project would be identical to conditions in the"Go Now" scenario shown above with the sole exception that the decision will be delayed until 2008. What is the NPV if the project is delayed for a year? Delay Decision: Invest Only If Conditions Are Good 2008 -$5.0 $0.0 2009 $2.5 $0.0 End of Period: 2010 2011 2012 $2.5 $2.5 $2.5 $0.0 $0.0 $0.0 Expected NPV Standard Deviation Coefficient of Variation

Good Conditions Bad but irrelevant

50% 50%

Delay Delay

Discount the expected NPV back 1 year to make it comparable to "go now" NPV Value of the Timing Option: NPV Considering the Timing Option NPV Without Considering the Timing Option Value of the Timing Option

Growth Options
Some projects provide the firm with opportunities to pursue other profitable projects in the future. Although a project appears to have a negative conventional NPV, it could be attractive if it opens the door to new products or markets. To illustrate, assume that Crum Corporation is considering a Chinese distribution center that requires an initial investment of $3 million. If conditions are strong, it will provide 3 annual cash flows of $1.5 million each. However, if conditions are weak, each annual cash flow will only be $0.75 million. There is a 50% probability for each condition. Crum's WACC is 12%. Management believes that if conditions are strong, this investment would lead to subsequent investment opportunities in Year 2 that would cost $10 million, and the investment could be sold for $20 million at the end of Year 3. What's the distribution center's NPV if we disregard the potential new investment? What would the NPV be giving consideration to the option? Analysis of a Growth Option Project Disregarding the Growth Option: End of Period NPV@

Distr Ctr

Good Bad

50% 50%

0 -$3.0 -$3.0

1 $1.500 $0.750

2 3 $1.500 $1.500 $0.750 $0.750 Expected NPV:

12% $0.603 -$1.199 -$0.298

Project Considering the Growth Option: Good Distr Ctr New Inv. 50% End of Period 0 1 2 -$3.000 $1.500 $1.500 -$10.000 -$3.000 $1.500 -$8.500 -$3.000 $0.750 3 $1.500 $20.000 $21.500 NPV@ 12%

NPV for good considering growth:

$6.866 -$1.199 $2.834



Distr Ctr


$0.750 $0.750 Total Expected NPV:

NPV considering growth: NPV not considering growth: Value of the growth option:

-$0.298 $3.132

Flexibility Options Flexibility options, where plants are designed to use alternative inputs and/or to produce alternative outputs depending on market conditions, are also important. For example, suppose BQC is considering a new plant with a cost of $5 million. There is a 50% probability of strong demand, in which case the project will provide annual cash flows of $2.5 million for 3 years, and a 50% probability of weak demand and cash flows of only $1.5 million. However, if demand is weak, the company can convert the plant and produce an alternative product, and in this case the cash flows in Years 2 and 3 would be $2.2 million. The situation is set forth in the decision tree below. In a conventional NPV analysis, only the upper tree would be considered, the NPV would be -$0.278, so the project would be rejected. However, if the flexibility option were considered, the lower tree would be relevant, the expected NPV would be $0.239, and the project would be accepted. Project Disregarding the Flexibility Option: Strong demand Weak demand 50% 50% 0 -$5.0 -$5.0 End of Period 1 2 3 $2.5 $2.5 $2.5 $1.5 $1.5 $1.5 Expected NPV: End of Period 1 2 3 $2.5 $2.5 $2.5 $1.5 $1.5 $1.5 $1.5 $2.2 $2.2 Expected NPV:

Project Considering the Flexibility Option: Strong demand Weak demand 50% 0% 50% 0 -$5.0 -$5.0 -$5.0

Don't switch products Switch products

lars in Thousands)

NPV @ 10% $2.92 -$1.20 $0.864 $2.060 2.38

NPV @ 10% $2.92 $0.00 $1.462 $1.462 1.00

$1.329 $1.329 $0.864 $0.465

NPV@ 13% $0.903 -$1.458 -$0.278 NPV@ 13% $0.903 -$1.458 -$0.425 $0.239


This model analyzes decisions related to replacing assets that are currently being used with more efficient assets. While the mechanics of the analysis are somewhat different from that 3 used for a new project, the concepts are identical. 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54

Input Data
Cost of the new machine Reduction in operating costs New machine's salvage value at end of Year 5 Old machine's current market value Old machine's current book value Increase in net operating working capital Tax rate WACC $12,000 $5,000 $2,000 $1,000 $2,500 $1,000 40% 11.5%

MACRS 3-year Depreciation Schedule

Depr. Rate


1 33% $3,960

2 45% $5,400

3 15% $1,800

4 7% $840 Years

Projected Cash Flows

0 Investment Outlays at Time Zero Cost of new equipment Market value of old equipment Tax savings on old equipment Increase in net working capital -$12,000 1,000 600 (1,000) 1 2

Operating Cash Flows over the Project's Life After-tax decrease in costs Depreciation on new machine Depreciation on old machine Change in depreciation Tax savings from depreciation Operating cash flows Terminal Year Cash Flows Estimated salvage value of new machine Tax on salvage value (40%) Return of net operating working capital Total termination cash flows Projected Cash Flows (CF timeline) -$11,400

$3,000 3,960 500 $3,460 1,384 $4,384

$3,000 5,400 500 $4,900 1,960 $4,960

$3,000 1,800 500 $1,300 520 $3,520

$3,000 840 500 $340 136 $3,136

$3,000 0 500 -$500 -200 $2,800

$2,000 -800 1,000 $2,200 $4,384 $4,960 $3,520 $3,136 $5,000

Appraisal of the Proposed Project

NPV (at 11.5%) IRR MIRR Payback (Excel function) Cumulative cash flow for payback: $3,991 25.03% 18.40% 2.58 0 ($11,400) 1 ($7,016) Years 2 3 ($2,056) $1,464 2.58 4 $4,600 5 $9,600 -

1 REFUNDING OPERATIONS (WEB APPENDIX 12C) 2 This example examines the issue of replacing existing debt with newly issued debt. At its core, this issue raises two important questions. First, "Is it profitable to call an outstanding issue and replace it with a new issue?" Second, even if refunding now is profitable, "Would the firm's expected value be 3 further increased if the refunding were postponed until a later date?" 4 The net present value method is used to analyze the advantages of refunding. The firm should refund only if the present value of the savings exceeds the cost of the refunding. The after-tax cost of debt should be used as the discount rate, since there is relative certainty to the cash flows to be received. Using the example laid out in Web Appendix 12C, we will now evaluate such a scenario.

5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35

Input Data (in thousands of dollars)

Existing bond issue Original flotation cost Maturity of original debt Years since old debt issue Call premium (%) Original coupon rate After-tax cost of new debt $60,000 $3,000 25 5 10% 12% 5.4% New New New New bond issue flotation cost bond maturity cost of debt $60,000 $2,650 20 9% 40% 6%

Tax rate
Short-term interest rate

Cash flow schedule

Before-tax Investment Outlay Call premium on the old bond Flotation costs on new issue Immediate tax savings on old flotation cost expense Extra interest paid on old issue Interest earned on short-term investment Total after-tax investment Annual Flotation Cost Tax Effects: t=1 to 20 Annual tax savings from new issue flotation costs Annual lost tax savings from old issue flotation costs Net flotation cost tax savings Annual Interest Savings Due to Refunding: t=1 to 20 Interest on old bond Interest on new bond Net interest savings -$6,000 -2,650 2,400 -600 300 After-tax -$3,600 -2,650 960 -360 180 -$5,470

$133 -120 $13

$53 -48 $5

$7,200 -5,400 $1,800

$4,320 -3,240 $1,080

Since the annual flotation cost tax effects and interest savings occur for the next 20 years, they represent annuities. To evaluate this project, we must find the present values of these savings. Using the function wizard and solving for present value, we find that the present values of these annuities 36 are: 37 38 Calculating the annual flotation cost tax effects and the annual interest savings 39 40 Annual flotation Cost Tax Effects Annual Interest Savings 41 Maturity of the new bond 20 Maturity of the new bond 20 42 After-tax cost of new debt 5.4% After-tax cost of new debt 5.4% 43 Annual flotation cost tax savings $5 Annual interest savings $1,080 44 45 NPV of flotation cost savings $60 NPV of annual interest savings $13,014 46 Hence, the net present value of this bond refunding project will be the sum of the initial outlay and the 47 present values of the annual flotation cost tax effects and interest savings. 48 49 50 Bond Refunding NPV = Initial Outlay + PV of flot. costs + PV of interest savings 51 Bond Refunding NPV = ($5,470) + $60 + $13,014 52 53 Bond Refunding NPV = $7,604 54

A B C D E F G H I Our refunding analysis tells us that should the firm proceed with the bond refunding, the project will have a positive net present value. However, unlike traditional capital budgeting decisions, the positive NPV does not tell the firm if it should refund the bond issue now. That decision is dependent upon 55 several external factors, including interest rate expectations. 56 57 58

A firm is considering two mutually exclusive projects, a conveyor system (Project C) or a fleet of forklift trucks (Project F), for moving materials. The cost of capital is 12%. We show a traditional analysis in Part I and modified analyses in Parts II and III. Two modifications can be used: The Replacement Chain method or the Equivalent Annual Annuity (EAA) method. These two approaches always reach the same conclusion.

Figure 12F-1. Analysis of Mutually Exclusive Projects with Unequal Lives

I. Traditional Analysis Project C 0 ($40,000) NPVC = $6,491 Project F 0 ($20,000) NPVF = $5,155 1 $7,000 1 $8,000 WACC = End of Period: 2 3 $14,000 $13,000 IRRC = 17.5% End of Period: 2 3 $13,000 $12,000 IRRF = 25.2% 4 $12,000 5 $11,000 6 $10,000 12%

Based on a traditional analysis, Project C appears to be the better investment. However, if the firm chooses Project F, it would have the opportunity (which is a real option) to repeat the investment 3 years from now. Therefore, we can reevaluate Project F using an extended life of 6 years. The time lines are shown below. Note that only F is changed. If the projects had had lives of say 3 and 7 years, then it would have been necessary to extend the analysis out to a common year, when both end, in this case to Year 21. II. Replacement Chain Method for Adjusting for Unequal Lives Project C: No change in the analysis 0 ($40,000) NPVC = 1 $8,000 $6,491 2 $14,000 3 4 $13,000 $12,000 IRRC = 17.5% WACC = 5 $11,000 12% 6 $10,000

Project F: Replacement Chain modification 0 ($20,000) ($20,000) NPVF = 1 $7,000 $7,000 $8,824 2 $13,000 $13,000 3 $12,000 ($20,000) ($8,000) IRRF = 4 $7,000 $7,000 25.2% 5 $13,000 $13,000 6 $12,000 $12,000

On the basis of the replacement chain analysis, we see that Project F is the better choice.

III. Equivalent Annual Annuity (EAA) Method for Adjusting

The unequal life problem was first tackled by electrical engineers who were designing power plants and distribution lines where they could use either assets with relatively low costs but relatively short lives or high initial costs and longer lives. The facilities were expected to be used forever (or at least as far as one could forecast), so the issue became this: Which choice would result in the higher NPV over an infinite life? The engineers decided to do an analysis where they took the varying annual cash flows and converted them into a constant cash flow stream whose NPV was equal to, or equivalent to, the NPV of the varying stream. To apply the EAA method to Projects C and F, we first find the constant cash flow that has the same NPV as the NPV we found using the traditonal analysis. For Project C, we need to find the constant CF for 6 years that results in the same NPV.

III. Equivalent Annual Annuity (EAA) Method for Adjusting for Unequal Lives
For Project C, insert these values into a calculator: N = 6, I/YR = 12%, PV = 6491, FV = 0, and then press PMT to find the constant annuity payment whose PV is $6,491. This payment is: EAAC = $1,578.78 Then do the same thing with Project F, using N = 3, I = 12%, PV = 5155, and FV = 0: FV = 0, getting PMT = EAAF = We could get the same results using Excel's PMT function. With the EAA method, we would choose the project with the higher EAA, Project F. We see that the EAA and replacement chain methods result in the same choice, Project F. The EAA method is easier to implement, but the replacement chain method is easier to explain to senior managers. Also, it is easier to modify the replacement chain data to reflect cost changes for the replaced assets and/or changes in the cash flows due to productivity improvements, inflation, and so on.



SOLUTIONS TO SELF-TEST QUESTIONS 1a If the WACC increased to 15% in Table 12-1, what would the new NPV be? WACC 15% 0 -$26,000 $2,877 1 $6,702 Years 2 $7,149 3 $6,733 4 $23,116