12problem 2/7/2010 18:25

Chapter 12. Solution to End-of-Chapter Comprehensive/Spreadsheet Problem

Problem 12-11

You must analyze a potential new product--a caulking compound that Cory Mateials' R&D people developed for use in the
residential construction industry. Cory's marketing manager thinks they can sell 115,000 tubes per year at a price of $3.25
each for 3 years, after which the product will be obsolete. The required equipment would cost $150,000, plus another $25,000
for shipping and installation. Current assets (receivables and inventories) would increase by $35,000, while current liabilities
(accounts payable and accruals) would rise by $15,000. Variable costs would be 60 percent of sales revenues, fixed costs
(exclusive of depreciation) would be $70,000 per year, and the fixed assets would be depreciated under MACRS with a 3-year life.
(Refer to Appendix 12A for MACRS depreciation rates.) When production ceases after 3 years, the equipment should have a
marekt value of $15,000. Cory's tax rate is 40 percent, and it uses a 10 percent WACC for average-risk projects.

a. Find the required Year 0 investment, the annual after-tax operaing cash flows, and the terminal year cash flow, and then
calculate the project's NPV, IRR, MIRR, and payback. Assume at this point that the project is of average risk.

Key Output: NPV = $0

IRR = #NUM!
Part 1. Key Input Data MIRR = #DIV/0!

Equipment cost plus installation 175,000 Market value of equipment in 2008

Increase in current assets 35,000 Tax rate
Increase in current liabilities 15,000 WACC
Unit sales 115,000
Sales price per unit 3.25
Variable cost per unit 60%
Variable cost per unit (in dollars) 1.95
Fixed costs 70,000

Part 2. Depreciation and Amortization Schedule Years Accum'd

Year Initial Cost 1 2 3 Deprn
0
Equipment Deprn Rate 33.0% 45.0% 15.0%
Equipment Deprn, Dollars $57,750 $78,750 $26,250 $162,750
Ending Bk Val: Cost - Accum'd Deprn 117,250 38,500 $12,250

Part 3. Net Salvage Values, in 2005 Equipment

Estimated Market Value in 2008 $15,000
Book Value in 2008 12,250
Expected Gain or Loss 2,750
Taxes paid or tax credit 1,100
Net cash flow from salvage $13,900

Part 4. Projected Net Cash Flows (Time line of annual cash flows)
Years, 1-4 basis 0 1 2 3
Years, actual year basis 2005 2006 2007 2008
Investment Outlays at Time Zero:
Equipment (175,000)
Increase in Net Operating WC (20,000)

Operating Cash Flows over the Project's Life:

Units sold 115,000 115,000 115,000
Sales price $3.25 $3.25 $3.25

Sales revenue $373,750 $373,750 $373,750

Variable costs 224,250 224,250 224,250
Fixed operating costs 70,000 70,000 70,000
Depreciation (equipment) 57,750 78,750 26,250
Oper. income before taxes (EBIT) 21,750 750 53,250
Taxes on operating income (40%) 8,700 300 21,300
Net Operating Profit After Taxes (NOPAT) 13,050 450 31,950
Add back depreciation 57,750 78,750 26,250
Operating cash flow $70,800 $79,200 $58,200
Terminal Year Cash Flows:
Return of net operating working capital 20,000
After-tax salvage value 13,900
Total termination cash flows $33,900

Net Cash Flow (Time line of cash flows) ($195,000) $70,800 $79,200 $92,100
Data for Payback Years 0 1 2 3
Cumulative CF from Row 53 (195,000) (124,200) (45,000) 47,100
IF Function to find payback N/A

b. Suppose you now learn that R&D costs for the new product were $30,000, and those costs were incurred and
expensed for tax purposes last year. How would this affect your estimate of NPV and other profitability measures?
The $30,000 R&D costs are sunk costs. Therefore, these costs will have no effect on NPV and other profitability
measures.

c. If the new project would reduce cash flows from Cory's other projects, and if the new project were to be housed
in an empty building that Cory owns and could sell if it chose to, how would those factors affect the project's NPV?
If the new project will reduce cash flows from the firm's other projects, then this is a negative externality and must
be considered in the analysis. Consequently, these should be considered costs of the new project and would reduce
the project's NPV. If the project can be housed in an empty building that the firm owns and could sell if it were not
used for the project, then this is an opportunity cost which should also be considered as a "cost" of this project.
The after-tax sales amount for this building will reduce the project's NPV.

d. Are this project's cash flows likely to be positively or negatively correlated with returns on Cory's other
projects and with the economy, and should this matter in your analysis? Explain.
The project's cash flows are likely to be positively correlated with returns on the firm's other projects and with
the economy. The firm is involved with materials and caulking compound is a building material, so it is a similar
product to the firm's other products. In addition, when the economy is booming, housing starts increase--which
would mean an increase in sales of the caulking compound. Whether a project is positively or negatively
correlated with the firm's other projects impacts the risk of the project and the relevant cost of capital at which
it should be evaluated.

e. Spreadsheet assignment: at instructor's option Construct a spreadsheet that calculates the cash flows, NPV,
IRR, payback, and MIRR.
See the spreadsheet used to answer part a of this problem.
f. The CEO expressed concern that some of the base-case inputs might be too optimistic or too pessimistic, and he
wants to know how the NPV would be affected if these 6 variables were all 20% better or 20% worse than
the base-case level: unit sales, sales price, variable costs, fixed costs, WACC, and equipment cost. Hold
other things constant when you consider each variable, and construct a sensitivity graph to illustrate your
results.

Sensitivity of NPV to Changes in Inputs. Here we use an Excel "Data Table" to find NPV
 1/9/2006

t Problem

ple developed for use in the

per year at a price of $3.25
150,000, plus another $25,000
5,000, while current liabilities
ales revenues, fixed costs
under MACRS with a 3-year life.
, the equipment should have a
age-risk projects.

inal year cash flow, and then

of average risk.

15,000
40%
10%
 re incurred and
profitability measures?
her profitability

t were to be housed
ect the project's NPV?
xternality and must
t and would reduce
uld sell if it were not
" of this project.

ojects and with

l, so it is a similar
increase--which

capital at which

sh flows, NPV,
pessimistic, and he
% worse than

lustrate your
12problem 2/7/2010 18:25

Chapter 12. Solution to End-of-Chapter Comprehensive/Spreadsheet Problem

Problem 12-11

You must analyze a potential new product--a caulking compound that Cory Mateials' R&D people developed for use in the
residential construction industry. Cory's marketing manager thinks they can sell 115,000 tubes per year at a price of $3.25
each for 3 years, after which the product will be obsolete. The required equipment would cost $150,000, plus another $25,000
for shipping and installation. Current assets (receivables and inventories) would increase by $35,000, while current liabilities
(accounts payable and accruals) would rise by $15,000. Variable costs would be 60 percent of sales revenues, fixed costs
(exclusive of depreciation) would be $70,000 per year, and the fixed assets would be depreciated under MACRS with a 3-year life.
(Refer to Appendix 12A for MACRS depreciation rates.) When production ceases after 3 years, the equipment should have a
marekt value of $15,000. Cory's tax rate is 40 percent, and it uses a 10 percent WACC for average-risk projects.

a. Find the required Year 0 investment, the annual after-tax operaing cash flows, and the terminal year cash flow, and then
calculate the project's NPV, IRR, MIRR, and payback. Assume at this point that the project is of average risk.

Key Output: NPV = $0

IRR = #NUM!
Part 1. Key Input Data MIRR = #DIV/0!

Equipment cost plus installation 175,000 Market value of equipment in 2008

Increase in current assets 35,000 Tax rate
Increase in current liabilities 15,000 WACC
Unit sales 115,000
Sales price per unit 3.25
Variable cost per unit 60%
Variable cost per unit (in dollars) 1.95
Fixed costs 70,000

Part 2. Depreciation and Amortization Schedule Years Accum'd

Year Initial Cost 1 2 3 Deprn
0
Equipment Deprn Rate 33.0% 45.0% 15.0%
Equipment Deprn, Dollars $57,750 $78,750 $26,250 $162,750
Ending Bk Val: Cost - Accum'd Deprn 117,250 38,500 $12,250

Part 3. Net Salvage Values, in 2005 Equipment

Estimated Market Value in 2008 $15,000
Book Value in 2008 12,250
Expected Gain or Loss 2,750
Taxes paid or tax credit 1,100
Net cash flow from salvage $13,900

Part 4. Projected Net Cash Flows (Time line of annual cash flows)
Years, 1-4 basis 0 1 2 3
Years, actual year basis 2005 2006 2007 2008
Investment Outlays at Time Zero:
Equipment (175,000)
Increase in Net Operating WC (20,000)

Operating Cash Flows over the Project's Life:

Units sold 115,000 115,000 115,000
Sales price $3.25 $3.25 $3.25

Sales revenue $373,750 $373,750 $373,750

Variable costs 224,250 224,250 224,250
Fixed operating costs 70,000 70,000 70,000
Depreciation (equipment) 57,750 78,750 26,250
Oper. income before taxes (EBIT) 21,750 750 53,250
Taxes on operating income (40%) 8,700 300 21,300
Net Operating Profit After Taxes (NOPAT) 13,050 450 31,950
Add back depreciation 57,750 78,750 26,250
Operating cash flow $70,800 $79,200 $58,200
Terminal Year Cash Flows:
Return of net operating working capital 20,000
After-tax salvage value 13,900
Total termination cash flows $33,900

Net Cash Flow (Time line of cash flows) ($195,000) $70,800 $79,200 $92,100
NPV (195,000) 64,364 65,455 69,196
Part 5. Key Output: Appraisal of the Proposed Project

Net Present Value (at 10%) $4,014 4,014

IRR 11.11%
MIRR #DIV/0! 3.49
Applies MIN function to Row 81 to find first year when payback
Payback; see calculation below) 2.49 is positive.

Data for Payback Years 0 1 2 3

Cumulative CF from Row 53 (195,000) (124,200) (45,000) 47,100
IF Function to find payback FALSE FALSE 0.49

b. Suppose you now learn that R&D costs for the new product were $30,000, and those costs were incurred and
expensed for tax purposes last year. How would this affect your estimate of NPV and other profitability measures?
The $30,000 R&D costs are sunk costs. Therefore, these costs will have no effect on NPV and other profitability
measures.

c. If the new project would reduce cash flows from Cory's other projects, and if the new project were to be housed
in an empty building that Cory owns and could sell if it chose to, how would those factors affect the project's NPV?
If the new project will reduce cash flows from the firm's other projects, then this is a negative externality and must
be considered in the analysis. Consequently, these should be considered costs of the new project and would reduce
the project's NPV. If the project can be housed in an empty building that the firm owns and could sell if it were not
used for the project, then this is an opportunity cost which should also be considered as a "cost" of this project.
The after-tax sales amount for this building will reduce the project's NPV.

d. Are this project's cash flows likely to be positively or negatively correlated with returns on Cory's other
projects and with the economy, and should this matter in your analysis? Explain.
The project's cash flows are likely to be positively correlated with returns on the firm's other projects and with
the economy. The firm is involved with materials and caulking compound is a building material, so it is a similar
product to the firm's other products. In addition, when the economy is booming, housing starts increase--which
would mean an increase in sales of the caulking compound. Whether a project is positively or negatively
correlated with the firm's other projects impacts the risk of the project and the relevant cost of capital at which
it should be evaluated.

e. Spreadsheet assignment: at instructor's option Construct a spreadsheet that calculates the cash flows, NPV,
IRR, payback, and MIRR.
See the spreadsheet used to answer part a of this problem.

f. The CEO expressed concern that some of the base-case inputs might be too optimistic or too pessimistic, and he
wants to know how the NPV would be affected if these 6 variables were all 20% better or 20% worse than
the base-case level: unit sales, sales price, variable costs, fixed costs, WACC, and equipment cost. Hold
other things constant when you consider each variable, and construct a sensitivity graph to illustrate your
results.

Sensitivity of NPV to Changes in Inputs. Here we use an Excel "Data Table" to find NPV
 1/9/2006

t Problem

ple developed for use in the

per year at a price of $3.25
150,000, plus another $25,000
5,000, while current liabilities
ales revenues, fixed costs
under MACRS with a 3-year life.
, the equipment should have a
age-risk projects.

inal year cash flow, and then

of average risk.

15,000
40%
10%
 199,014 (195,000)

year when payback

0.65

re incurred and
profitability measures?
her profitability

t were to be housed
ect the project's NPV?
xternality and must
t and would reduce
uld sell if it were not
" of this project.

ojects and with

l, so it is a similar
increase--which

capital at which

sh flows, NPV,

pessimistic, and he
% worse than

lustrate your
 Time 0 1 2 3 4
Cash Flow -10000 5000 4000 3000 1000
Cumulated CF -5000 -1000 2000 3000
Payback Period N/A N/A N/A 2.33 N/A

YEAR1 IF(AND(TIME>0,B4="N/A"), (CF0+(CF1-CUMULATED CF1)/CF1),"N/A")

 Time 0 1 2 3
Cash Flow -195000 70800 79200 92100
Cumulated CF -124200 -45000 47100
Payback Period N/A N/A N/A 2.49

YEAR1 IF(AND(TIME>0,B4="N/A"), (CF0+(CF1-CUMULATED CF1)/CF1),"N/A")

-195000 70800 79200 92100

-195000 -124200 -45000 47100