Solutions To End-Of-Chapter Problems: - 17 - 1 0.00 $18,540,00 7.59 $21,750,22 E (NPV) CV

Chapter 12
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
12-1
Equipment
NOWC Investment
Initial investment outlay
$ 9,000,000
3,000,000
$12,000,000
12-2
Operating Cash Flows: t = 1

Sales revenues
Operating costs
Depreciation
Operating income before taxes
Taxes (40%)
Operating income after taxes
Add back depreciation
Operating cash flow
$10,000,000
7,000,000
2,000,000
$ 1,000,000
400,000
$
600,000
2,000,000
$ 2,600,000
Equipments original cost

Depreciation (80%)
Book value
$20,000,000
16,000,000
$ 4,000,000
12-3
Gain on sale = $5,000,000 - $4,000,000 = $1,000,000.

Tax on gain = $1,000,000(0.4) = $400,000.
AT net salvage value = $5,000,000 - $400,000 = $4,600,000.
12-4
Expected NPV = (0.3)(-$10,800) + (0.5)($23,400) + (0.2)($50,400)

= -$3,240 + $11,700 + $10,080
= $18,540.
Since NPV is stated in thousands, E(NPV) = $18,540,000.
NPV = [(0.3)(-$10,800 - $18,540)2 + (0.5)($23,400 - $18,540)2 + (0.2)
($50,400 - $18,540)2]
= [$258,250,680 + $11,809,800 + $203,011,920]
= $21,750.23.
Since NPV is stated in thousands NPV = $21,750,227.59.
CV
NPV
$21,750,227.59
1.17.
E(NPV) $18,540,000.00
Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.
Answers and Solutions: 12 - 1
12-5
CV
12-6
E(NPV) = 0.05(-$70) + 0.20(-$25) + 0.50($12) + 0.20($20) + 0.05($30)

= -$3.5 + -$5.0 + $6.0 + $4.0 + $1.5
= $3.0 million.
NPV = [0.05(-$70 - $3)2 + 0.02(-$25 - $3)2 + 0.50($12 - $3)2 +
0.20($20 - $3)2 + 0.05($30 - $3)2]
= $23.622 million.
$23.622
7.874.
$3.0
a.
Initial investment
Net oper. WC
0
($250,000)
(25,000)
Cost savings
Depreciation
Oper. inc. before taxes
Taxes (40%)
Oper. Inc. (AT)
Add: Depreciation
Oper. CF
Return of NOWC
Sale of Machine
Tax on sale (40%)
Net cash flow
$ 90,000 $ 90,000 $ 90,000

82,500
112,500
37,500
$ 7,500 ($ 22,500) $ 52,500
3,000
(9,000)
21,000
$ 4,500 ($ 13,500) $ 31,500
82,500
112,500
37,500
$ 87,000 $ 99,000 $ 69,000
($275,000) $ 87,000
$ 99,000
$ 69,000
$ 90,000
17,500
$ 72,500
29,000
$ 43,500
17,500
$ 61,000
$ 90,000
0
$ 90,000
36,000
$ 54,000
0
$ 54,000
$ 61,000
$25,000
23,000
(9,200)
$ 92,800
NPV = $37,035.13
Notes:
a
Depreciation Schedule, Basis = $250,000
Year
1
2
3
4
Beg. Bk. Value

$250,000
167,500
55,000
17,500
b. If savings increase
($90,000)
= $108,000.
If
savings
decrease
MACRS Rate
0.33
0.45
0.15
0.07
MACRS Rate
Basis =
Depreciation
$ 82,500
112,500
37,500
17,500
$250,000
Ending BV
$167,500
55,000
17,500
0
by
20
percent,
then
savings
will
be
(1.2)
by
20
percent,
then
savings
will
be
(0.8)
($90,000)
= $72,000.
(1) Savings increase by 20%:

Initial investment
Net oper. WC
0
($250,000)
(25,000)
Cost savings
Depreciation
Taxes (40%)
Oper. Inc. (AT)
Add: Depreciation
Oper. CF
Return of NOWC
Sale of Machine
Tax on sale (40%)
Net cash flow
$108,000 $108,000 $108,000

82,500
112,500
37,500
$ 25,500 ($ 4,500) $ 70,500
10,200
(1,800)
28,200
$ 15,300 ($ 2,700) $ 42,300
82,500
112,500
37,500
$ 97,800 $109,800 $ 79,800
($275,000) $ 97,800
$108,000
17,500
$ 90,500
36,200
$ 54,300
17,500
$ 71,800
$108,000
0
$108,000
43,200
$ 64,800
0
$ 64,800
$25,000
23,000
(9,200)
$103,600
$109,800
$ 79,800
$ 71,800
NPV = $77,975.63
(2) Savings decrease by 20%:
Initial investment
Net oper. WC
0
($250,000)
(25,000)
Cost savings
Depreciation
Taxes (40%)
Oper. Inc. (AT)
Add: Depreciation
Oper. CF
Return of NOWC
Sale of Machine
Tax on sale (40%)
Net cash flow
$ 72,000 $ 72,000
82,500
112,500
($ 10,500)($ 40,500)
(4,200) (16,200)
($ 6,300)($ 24,300)
82,500
112,500
$ 76,200 $ 88,200
($275,000) $ 76,200
$ 72,000
37,500
$ 34,500
13,800
$ 20,700
37,500
$ 58,200
$ 72,000
17,500
$ 54,500
21,800
$ 32,700
17,500
$ 50,200
$ 72,000
0
$ 72,000
28,800
$ 43,200
0
$ 43,200
$25,000
23,000
(9,200)
$ 82,000
$ 88,200
$ 58,200
$ 50,200
NPV = -$3,905.37
c. Worst-case scenario:
Initial investment
Net oper. WC
0
($250,000)
(30,000)
Cost savings
Depreciation
Taxes (40%)
Oper. Inc. (AT)
Add: Depreciation
Oper. CF
Return of NOWC
Sale of Machine
Tax on sale (40%)
Net cash flow
$ 72,000 $ 72,000
82,500
112,500
($ 10,500)($ 40,500)
(4,200) (16,200)
($ 6,300)($ 24,300)
82,500
112,500
$ 76,200 $ 88,200
($280,000) $ 76,200
$ 88,200
$ 72,000
37,500
$ 34,500
13,800
$ 20,700
37,500
$ 58,200
$ 58,200
$ 72,000
17,500
$ 54,500
21,800
$ 32,700
17,500
$ 50,200
$ 72,000
0
$ 72,000
28,800
$ 43,200
0
$ 43,200
$ 50,200
$30,000
18,000
(7,200)
$ 84,000
NPV = -$7,663.52
Base-case scenario:
This was worked out in part a.
NPV = $37,035.13.
Best-case scenario:
Initial investment
Net oper. WC
0
($250,000)
( 20,000)
Cost savings
Depreciation
Taxes (40%)
Oper. Inc. (AT)
Add: Depreciation
Oper. CF
Return of NOWC
Sale of Machine
Tax on sale (40%)
Net cash flow
$108,000 $108,000 $108,000

82,500
112,500
37,500
$ 25,500 ($ 4,500) $ 70,500
10,200
(1,800)
28,200
$ 15,300 ($ 2,700) $ 42,300
82,500
112,500
37,500
$ 97,800 $109,800 $ 79,800
($270,000) $ 97,800
$109,800
$ 79,800
$108,000
17,500
$ 90,500
36,200
$ 54,300
17,500
$ 71,800
$108,000
0
$108,000
43,200
$ 64,800
0
$ 64,800
$ 71,800
$20,000
28,000
(11,200)
$101,600
NPV = $81,733.79
Prob.
Worst-case
Base-case
Best-case
Prob. NPV
($ 7,663.52)
($ 2,682.23)
37,035.13
12,962.30
81,733.79
24,520.14
E(NPV) $34,800.21
NPV
0.35
0.35
0.30
NPV = [(0.35)(-$7,663.52 - $34,800.21)2 + (0.35)($37,035.13 $34,800.21)2 + (0.30)($81,733.79 - $34,800.21)2]

NPV = [$631,108,927.93 + $1,748,203.59 + $660,828,279.49]
NPV = $35,967.84.
CV = $35,967.84/$34,800.21 = 1.03.
12-7
a. The net cost is $178,000:

Cost of investment at t = 0:
Base price
Modification
Increase in NOWC
Cash outlay for new machine
($140,000)
(30,000)
(8,000)
($178,000)
b. The operating cash flows follow:

After-tax savings
Depreciation tax savings
Net operating cash flow
Year 1
$30,000
22,440
$52,440
Year 2
$30,000
30,600
$60,600
Year 3
$30,000
10,200
$40,200
Notes:
1. The after-tax cost savings is $50,000(1 T) = $50,000(0.6) =
$30,000.
2. The depreciation expense in each year is the depreciable basis,
$170,000, times the MACRS allowance percentages of 0.33, 0.45, and
0.15 for Years 1, 2, and 3, respectively. Depreciation expense in
Years 1, 2, and 3 is $56,100, $76,500, and $25,500. The
depreciation tax savings is calculated as the tax rate (40
percent) times the depreciation expense in each year.
c. The terminal cash flow is $48,760:
Salvage value
Tax on SV*
Return of NOWC
$60,000
(19,240)
8,000
$48,760
Remaining BV in Year 4 = $170,000(0.07) = $11,900.

*Tax on SV = ($60,000 - $11,900)(0.4) = $19,240.
d. The project
accepted.
Year
0
1
2
3
has
an
NPV
Net Cash Flow

($178,000)
52,440
60,600
88,960
NPV =
of
($19,549).
Thus,
it
should
not
be
PV @ 12%
($178,000)
46,821
48,310
63,320
($ 19,549)
Alternatively, place the cash flows on a time line:

0
10%
|
-178,000
1
|
52,440
2
|
60,600
3
|
40,200
48,760
88,960
With a financial calculator, input the appropriate cash flows into

the cash flow register, input I = 12, and then solve for NPV = $19,549.
12-8
a. The net cost is $126,000:

Price
Modification
Increase in NOWC
Cash outlay for new machine
($108,000)
(12,500)
(5,500)
($126,000)
b. The operating cash flows follow:

Year 1
$28,600
13,918
$42,518
1. After-tax savings
2. Depreciation tax savings
Net cash flow
Year 2
$28,600
18,979
$47,579
Year 3
$28,600
6,326
$34,926
Notes:
1. The after-tax cost savings is $44,000(1 - T) = $44,000(0.65)
= $28,600.
2. The depreciation expense in each year is the depreciable basis,
$120,500, times the MACRS allowance percentages of 0.33, 0.45, and
0.15 for Years 1, 2, and 3, respectively. Depreciation expense in
Years 1, 2, and 3 is $39,765, $54,225, and $18,075. The
depreciation tax savings is calculated as the tax rate (35
percent) times the depreciation expense in each year.
c. The terminal cash flow is $50,702:
Salvage value
Tax on SV*
Return of NOWC
$65,000
(19,798)
5,500
$50,702
BV in Year 4 = $120,500(0.07) = $8,435.

*Tax on SV = ($65,000 - $8,435)(0.35) = $19,798.
d. The project has an NPV of $10,841; thus, it should be accepted.
Year
0
1
2
3
Net Cash Flow

PV @ 12%
($126,000)
($126,000)
42,518
37,963
47,579
37,930
85,628
60,948
NPV = $ 10,841
Alternatively, place the cash flows on a time line:

0
10%
|
-126,000
1
|
42,518
2
|
47,579
3
|
34,926
50,702
85,628
With a financial calculator, input the appropriate cash flows into

the cash flow register, input I = 12, and then solve for NPV =
$10,841.
12-9
a. Expected annual cash flows:

Project A:
Probable
Probability Cash Flow
=
Cash Flow
0.2
$6,000
$1,200
0.6
6,750
4,050
0.2
7,500
1,500
Expected annual cash flow = $6,750
Project B:
Probable
Probability Cash Flow
=
Cash Flow
0.2
$
0
$
0
0.6
6,750
4,050
0.2
18,000
3,600
Expected annual cash flow = $7,650
Coefficient of variation:
CV
Standard deviation
NPV
Expected value
Expected NPV
Project A:
A
($750)2(0.2) ($0)2(0.6) ($750)2(0.2) $474.34.
Project B:
B ($7,650)2(0.2) ($900)2(0.6) ($10,350)2(0.2) $5,797.84.
CVA = $474.34/$6,750 = 0.0703.

CVB = $5,797.84/$7,650 = 0.7579.
b.
Project B is the riskier project because it has the greater variability

in its probable cash flows, whether measured by the standard
deviation or the coefficient of variation.
Hence, Project B is
evaluated at the 12 percent cost of capital, while Project A requires
only a 10 percent cost of capital.
NPVA
= $6,750(PVIFA10%,3) - $6,750 = $6,750(2.4869) - $6,750

= $16,786.58 - $6,750 = $10,036.58 $10,037.
Alternatively, with a financial calculator, input the appropriate cash

flows into the cash flow register, input I = 10, and then solve for
NPV = $10,036.25.
NPVB
= $7,650(PVIFA12%,3) - $6,750 = $7,650(2.4018) - $6,750

= $18,373.77 - $6,750 = $11,623.77 $11,624.
Alternatively, with a financial calculator, input the appropriate cash

flows into the cash flow register, input I = 12, and then solve for
NPV = $11,624.01.
Project B has the higher NPV; therefore, the firm should accept
Project B.
c.
The portfolio effects from Project B would tend to make it less risky
than otherwise. This would tend to reinforce the decision to accept
Project B. Again, if Project B were negatively correlated with the
GDP (Project B is profitable when the economy is down), then it is
less risky and Project B's acceptance is reinforced.
12-10 If actual life is 5 years:
Outflows:
Investment in
new equipment
Total PV of outflows
Inflows:
Pre-tax operating
cash flows
Depreciation
Amount
before
tax
Amount
after
tax
Year
Event
Occurs
$36,000
$36,000
$12,000
7,200
$ 7,200
2,880
1-5
1-5
PV
Factor
at 10%
PV
1.0
$36,000
$36,000
3.7908
3.7908
$27,294
10,918
$38,212
NPV = PV(Inflows) - PV(Outflows) = $38,212 - $36,000 = $2,212.

Alternatively, using a time line approach:
0 10%
|
|
|
|
Investment outlay
Operating cash flows
excl. deprec. (AT)
Depreciation savings
Net cash flow
5
|
|
(36,000)
(36,000)
7,200
2,880
10,080
7,200
2,880
10,080
7,200
2,880
10,080
7,200
2,880
10,080
7,200
2,880
10,080
NPV10% = $2,211.13.
If actual life is 4 years:
Amount
before
tax
Inflows:
Revenues
Depreciation
Tax savings on loss
at end of Year 4
Amount
after
tax
Year
Event
Occurs
PV
Factor
at 10%
PV
$12,000
7,200
$7,200
2,880
1-4
1-4
3.1699
3.1699
$22,823
9,129
7,200
2,880
0.6830
1,967
$33,919
NPV = $33,919 - $36,000 = -$2,081.

Alternatively, using a time line approach:
Investment outlay
excl. deprec. (AT)
Tax savings on loss
Net cash flow
0
|
(36,000)
1
10%
|
2
|
3
|
4
|
7,200
2,880
7,200
2,880
7,200
2,880
(36,000) 10,080
10,080
10,080
7,200
2,880
2,880
12,960
NPV10% = -$2,080.68.
If actual life is 8 years:
Inflows:
Revenues
Depreciation
Amount
before
tax
Amount
after
tax
Year
Event
Occurs
PV
Factor
at 10%
$12,000
7,200
$7,200
2,880
1-8
1-5
5.3349
3.7908
PV
$38,411
10,918
$49,329
NPV = $49,329 - $36,000 = $13,329.

Alternatively, using a time line
10%approach:
0
|
(36,000)
1
|
Investment outlay
excl. deprec. (AT)
7,200
2,880
Net cash flow
(36,000) 10,080
5
|
7,200
2,880
10,080
6
|
7
|
8
|
7,200
7,200
7,200
7,200
7,200
7,200
NPV10% = $13,328.93.
If the life is as low as 4 years (an unlikely event), the investment
will not be desirable.
But, if the investment life is longer than 4
years, the investment will be a good one. Therefore, the decision will
depend on the directors' confidence in the life of the tractor. Given
the low proba-bility of the tractor's life being only 4 years, it is
likely that the directors will decide to purchase the tractor.
SPREADSHEET PROBLEM
12-11 The detailed solution for the spreadsheet problem is available both on
the instructors resource CD-ROM and on the instructors side of the
Harcourt
College
Publishers
web
site,
http://www.harcourtcollege.com/finance/ brigham.
CYBERPROBLEM
12-12 The detailed solution for the cyberproblem is available on the

instructors side of the Harcourt College Publishers web site,
http://www. harcourtcollege.com/finance/brigham.
Computer/Internet Applications: 12 - 10
Harcourt, Inc.
Harcourt, Inc. items and derived items copyright 2000 by
INTEGRATED CASE
Allied Food Products

Capital Budgeting and Cash Flow Estimation
12-13
AFTER SEEING SNAPPLES SUCCESS WITH NONCOLA SOFT DRINKS AND LEARNING
OF COKES AND PEPSIS INTEREST, ALLIED FOOD PRODUCTS HAS DECIDED TO
CONSIDER AN EXPANSION OF ITS OWN IN THE FRUIT JUICE BUSINESS.
PRODUCT BEING CONSIDERED IS FRESH LEMON JUICE.
THE
ASSUME THAT YOU WERE
RECENTLY HIRED AS ASSISTANT TO THE DIRECTOR OF CAPITAL BUDGETING, AND

YOU MUST EVALUATE THE NEW PROJECT.
THE LEMON JUICE WOULD BE PRODUCED IN AN UNUSED BUILDING ADJACENT
TO ALLIEDS FORT MYERS PLANT; ALLIED OWNS THE BUILDING, WHICH IS
FULLY DEPRECIATED.
THE REQUIRED EQUIPMENT WOULD COST $200,000, PLUS
AN ADDITIONAL $40,000 FOR SHIPPING AND INSTALLATION.
IN ADDITION,
INVENTORIES WOULD RISE BY $25,000, WHILE ACCOUNTS PAYABLE WOULD GO UP

BY $5,000.
ALL OF THESE COSTS WOULD BE INCURRED AT t = 0. BY A
SPECIAL RULING, THE MACHINERY COULD BE DEPRECIATED UNDER THE MACRS

SYSTEM
AS
3-YEAR PROPERTY.
THE PROJECT IS EXPECTED TO OPERATE FOR 4 YEARS, AT WHICH TIME IT
WILL BE TERMINATED.
THE CASH INFLOWS ARE ASSUMED TO BEGIN 1 YEAR
AFTER THE PROJECT IS UNDERTAKEN, OR AT t = 1, AND TO CONTINUE OUT TO

t = 4. AT THE END OF THE PROJECTS LIFE (t = 4), THE EQUIPMENT IS
EXPECTED TO HAVE A SALVAGE VALUE OF $25,000.
UNIT SALES ARE EXPECTED TO TOTAL 100,000 CANS PER YEAR, AND THE
EXPECTED SALES PRICE IS $2.00 PER CAN.
CASH OPERATING COSTS FOR THE
PROJECT (TOTAL OPERATING COSTS LESS DEPRECIATION) ARE EXPECTED TO

TOTAL 60 PERCENT OF DOLLAR SALES.
ALLIEDS TAX RATE IS 40 PERCENT,
AND ITS WEIGHTED AVERAGE COST OF CAPITAL IS 10 PERCENT.
TENTATIVELY,
THE LEMON JUICE PROJECT IS ASSUMED TO BE OF EQUAL RISK TO ALLIEDS

OTHER ASSETS.
YOU
HAVE
BEEN
ASKED
TO
EVALUATE
THE
PROJECT
AND
TO
MAKE
RECOMMENDATION AS TO WHETHER IT SHOULD BE ACCEPTED OR REJECTED.

A
TO
Integrated Case: 12 - 11
GUIDE YOU IN YOUR ANALYSIS, YOUR BOSS GAVE YOU THE FOLLOWING SET OF
QUESTIONS.
TABLE IC12-1. ALLIEDS LEMON JUICE PROJECT

(TOTAL COST IN THOUSANDS)
END OF YEAR:
$ 2.00
100
$ 2.00
I. INVESTMENT OUTLAY
EQUIPMENT COST
INSTALLATION
INCREASE IN INVENTORY
INCREASE IN ACCOUNTS PAYABLE
TOTAL NET INVESTMENT
II. OPERATING CASH FLOWS
UNIT SALES (THOUSANDS)
PRICE/UNIT
TOTAL REVENUES
OPERATING COSTS,
EXCLUDING DEPRECIATION
DEPRECIATION
TOTAL COSTS
OPERATING INCOME BEFORE TAXES
TAXES ON OPERATING INCOME
OPERATING INCOME AFTER TAXES
DEPRECIATION
OPERATING CASH FLOW
$
$200.0
$120.0
$199.2
$228.0
36.0
16.8
$ 44.0
0.3
0.0
79.2
$ 79.7
25.3
$ 26.4
36.0
$ 54.7
III. TERMINAL YEAR CASH FLOWS

RETURN OF NET OPERATING WORKING CAPITAL
SALVAGE VALUE
TAX ON SALVAGE VALUE
TOTAL TERMINATION CASH FLOWS
IV. NET CASH FLOWS
NET CASH FLOW
($260.0)
$ 89.7
V. RESULTS
NPV =
IRR =
MIRR =
PAYBACK =
A.
DRAW A TIME LINE THAT SHOWS WHEN THE NET CASH INFLOWS AND OUTFLOWS
WILL OCCUR, AND EXPLAIN HOW THE TIME LINE CAN BE USED TO HELP
STRUCTURE THE ANALYSIS.
ANSWER:
[SHOW S12-1 THROUGH S12-4 HERE.]

0
|
CF0
1
|
CF1
2
|
CF2
3
|
CF3
4
|
CF4
TIME LINES ARE HELPFUL FOR SHOWING WHERE CASH FLOWS OCCUR.
WHEN THE
DATA ARE DEVELOPED, AND NUMBERS HAVE BEEN PUT ON THE TIME LINE, IT
FACILITATES INPUTTING THE CASH FLOWS INTO A CALCULATOR TO CALCULATE
THE NPV, IRR, MIRR, AND PAYBACK.
B.
ALLIED HAS A STANDARD FORM THAT IS USED IN THE CAPITAL BUDGETING

PROCESS; SEE TABLE IC12-1.
PART OF THE TABLE HAS BEEN COMPLETED, BUT
YOU MUST REPLACE THE BLANKS WITH THE MISSING NUMBERS.
COMPLETE THE
TABLE IN THE FOLLOWING STEPS:

1. FILL IN THE BLANKS UNDER YEAR 0 FOR THE INITIAL INVESTMENT OUTLAY.
ANSWER:
[SHOW
S12-5
HERE.]
THIS
ANSWER
IS
STRAIGHTFORWARD.
NOTE
THAT
ACCOUNTS PAYABLE IS AN OFFSET TO THE INVENTORY BUILDUP, SO THE NET

OPERATING
WORKING
CAPITAL
REQUIREMENT
IS
$20,000,
WHICH
WILL
BE
RECOVERED AT THE END OF THE PROJECTS LIFE. [SEE COMPLETED TABLE IN

THE ANSWER TO B5.]
B.
2. COMPLETE THE TABLE FOR UNIT SALES, SALES PRICE, TOTAL REVENUES, AND
OPERATING COSTS EXCLUDING DEPRECIATION.
ANSWER:
THIS ANSWER REQUIRES NO EXPLANATION.
STUDENTS MAY NOTE, THOUGH, THAT
INFLATION IS NOT REFLECTED AT THIS POINT.
IT WILL BE LATER.
[THE
COMPLETED TABLE IS SHOWN BELOW IN THE ANSWER TO B5.]
B.
3. COMPLETE THE DEPRECIATION DATA.
ANSWER:
[SHOW S12-6 HERE.]
THE ONLY THING THAT REQUIRES EXPLANATION HERE IS
THE USE OF THE DEPRECIATION TABLES IN APPENDIX 12A.
HERE ARE THE
RATES FOR 3-YEAR PROPERTY; THEY ARE MULTIPLIED BY THE DEPRECIABLE

BASIS, $240,000, TO GET THE ANNUAL DEPRECIATION ALLOWANCES:
(DOLLARS IN THOUSANDS)
YEAR
YEAR
YEAR
YEAR
B.
1
2
3
4
0.33
0.45
0.15
0.07
1.00
$240
$240
$240
$240
= $ 79.2
= 108.0
=
36.0
=
16.8
$240.0
4. NOW COMPLETE THE TABLE DOWN TO OPERATING INCOME AFTER TAXES, AND THEN
DOWN TO NET CASH FLOWS.
ANSWER:
[SHOW S12-7 HERE.]
THIS IS STRAIGHTFORWARD.
THE ONLY EVEN SLIGHTLY
COMPLICATED THING IS ADDING BACK DEPRECIATION TO GET NET CF.
[THE
COMPLETED TABLE IS SHOWN BELOW IN THE ANSWER TO B5.]
B.
5. NOW FILL IN THE BLANKS UNDER YEAR 4 FOR THE TERMINATION CASH FLOWS,
AND COMPLETE THE NET CASH FLOW LINE.
CAPITAL.
DISCUSS NET OPERATING WORKING
WHAT WOULD HAVE HAPPENED IF THE MACHINERY WERE SOLD FOR
LESS THAN ITS BOOK VALUE?

ANSWER:
[SHOW S12-8 HERE.]
THESE ARE ALL STRAIGHTFORWARD.
NOTE THAT THE NET
OPERATING WORKING CAPITAL REQUIREMENT IS RECOVERED AT THE END OF

YEAR 4.
ALSO, THE SALVAGE VALUE IS FULLY TAXABLE, BECAUSE THE ASSET
HAS BEEN DEPRECIATED TO A ZERO BOOK VALUE.
IF BOOK VALUE WERE
SOMETHING OTHER THAN ZERO, THE TAX EFFECT COULD BE POSITIVE (IF THE
ASSET WERE SOLD FOR LESS THAN BOOK VALUE) OR NEGATIVE.

INPUTS:
PRICE:
VC RATE:
$2.00
60.0%
k:
T-RATE:
END OF YEAR:
EQUIPMENT COST
INSTALLATION
10.0%
40%
INFL:
0.0%
100
$ 2.00
$200.0
100
$ 2.00
$200.0
100
$ 2.00
$200.0
100
$ 2.00
$200.0
$120.0
79.2
$199.2
$ 0.8
0.3
$ 0.5
79.2
$ 79.7
$120.0
108.0
$228.0
($ 28.0)
(11.2)
($ 16.8)
108.0
$ 91.2
$120.0
36.0
$156.0
$ 44.0
17.6
$ 26.4
36.0
$ 62.4
$120.0
16.8
$136.8
$ 63.2
25.3
$ 37.9
16.8
$ 54.7
($200)
(40)
(25)
5
(260)

PRICE/UNIT
TOTAL REVENUES
OPERATING COSTS,
DEPRECIATION
TOTAL COSTS
DEPRECIATION
OPERATING CASH FLOW
$
0.0

SALVAGE VALUE
IV. NET CASH FLOWS
NET CASH FLOW
($260.0)
CUMULATIVE CASH FLOW

FOR PAYBACK:
(260.0)
COMPOUNDED INFLOWS FOR MIRR:
TERMINAL VALUE OF INFLOWS:
$ 79.7
(180.3)
106.1
20.0
25.0
(10.0)
$ 35.0
$ 91.2
(89.1)
110.4
$ 62.4
(26.7)
68.6
$ 89.7
63.0
89.7
374.8
V. RESULTS
NPV =
-$4.0
IRR =
9.3%
MIRR =
9.6%
PAYBACK =
3.3 YEARS
C.
1. ALLIED USES DEBT IN ITS CAPITAL STRUCTURE, SO SOME OF THE MONEY USED
TO FINANCE THE PROJECT WILL BE DEBT. GIVEN THIS FACT, SHOULD THE
PROJECTED CASH FLOWS BE REVISED TO SHOW PROJECTED INTEREST CHARGES?
EXPLAIN.
ANSWER:
[SHOW S12-9 HERE.]
THE PROJECTED CASH FLOWS IN THE TABLE SHOULD NOT
BE REVISED TO SHOW INTEREST CHARGES.
THE EFFECTS OF DEBT FINANCING
ARE REFLECTED IN THE COST OF CAPITAL, WHICH IS USED TO DISCOUNT THE

CASH FLOWS.
C.
2. SUPPOSE YOU LEARNED THAT ALLIED HAD SPENT $50,000 TO RENOVATE THE
BUILDING LAST YEAR, EXPENSING THESE COSTS.
REFLECTED IN THE ANALYSIS?
ANSWER:
[SHOW S12-10 HERE.]
SHOULD THIS COST BE
EXPLAIN.
THIS EXPENDITURE IS A SUNK COST, HENCE IT WOULD
NOT AFFECT THE DECISION AND SHOULD NOT BE INCLUDED IN THE ANALYSIS.
C.
3. NOW SUPPOSE YOU LEARNED THAT ALLIED COULD LEASE ITS BUILDING TO
ANOTHER
PARTY
AND
EARN
$25,000
REFLECTED IN THE ANALYSIS?

ANSWER:
[SHOW S12-11 HERE.]
PER
YEAR.
SHOULD
THAT
FACT
BE
IF SO, HOW?
THE RENTAL PAYMENT REPRESENTS AN OPPORTUNITY
COST, AND AS SUCH ITS AFTER-TAX AMOUNT, $25,000(1 - T) = $25,000(0.6)

= $15,000, SHOULD BE SUBTRACTED FROM THE CASH FLOWS THE COMPANY WOULD
OTHERWISE HAVE.
C.
4. NOW ASSUME THAT THE LEMON JUICE PROJECT WOULD TAKE AWAY PROFITABLE
SALES FROM ALLIEDS FRESH ORANGE JUICE BUSINESS.
REFLECTED IN YOUR ANALYSIS?
ANSWER:
[SHOW S12-12 HERE.]
SHOULD THAT FACT BE
IF SO, HOW?
THE DECREASED SALES FROM ALLIEDS FRESH ORANGE
JUICE BUSINESS SHOULD BE ACCOUNTED FOR IN THE ANALYSIS. THIS IS AN

EXTERNALITY TO ALLIED--THE LEMON JUICE PROJECT WILL AFFECT THE CASH
FLOWS TO ITS ORANGE JUICE BUSINESS.
SINCE THE LEMON JUICE PROJECT
WILL TAKE BUSINESS AWAY FROM ITS ORANGE JUICE BUSINESS, THE REVENUES
AS SHOWN IN THIS ANALYSIS ARE OVERSTATED, AND THUS THEY NEED TO BE
REDUCED BY THE AMOUNT OF DECREASED REVENUES FOR THE ORANGE JUICE
BUSINESS. EXTERNALITIES ARE OFTEN DIFFICULT TO QUANTIFY, BUT THEY

NEED TO BE CONSIDERED.
D.
DISREGARD ALL THE ASSUMPTIONS MADE IN PART C, AND ASSUME THERE WAS NO
ALTERNATIVE
USE
FOR
THE
BUILDING
OVER
THE
NEXT
YEARS.
CALCULATE THE PROJECTS NPV, IRR, MIRR, AND REGULAR PAYBACK.
NOW
DO
THESE INDICATORS SUGGEST THAT THE PROJECT SHOULD BE ACCEPTED?

ANSWER:
WE REFER TO THE COMPLETED TIME
LINE AND EXPLAIN HOW EACH OF THE INDICATORS IS CALCULATED. WE BASE

OUR EXPLANATION ON FINANCIAL CALCULATORS, BUT IT WOULD BE EQUALLY
EASY TO EXPLAIN USING A REGULAR CALCULATOR AND EITHER EQUATIONS OR
TABLES.
0
10%
|
(260)
NPV = -$4.0.
1
|
79.7
2
|
91.2
3
|
62.4
4
|
89.7
NPV IS NEGATIVE; DO NOT ACCEPT.
IRR = $260
$79.7
$91.2
$62.4
$89.7
0.
1
2
3
(1 IRR) (1 IRR) (1 IRR) (1 IRR)4
IRR = 9.3%.
IRR IS LESS THAN COST OF CAPITAL; DO NOT ACCEPT.
MIRR:
0
10%
|
(260)
PV OF TV
NPV
$260
$ 0
1
|
79.7
MIRR = 9.6%
2
|
91.2
3
|
62.4
TERMINAL VALUE (TV)
4
|
89.7
68.6
110.4
106.1
$374.8
MIRR IS LESS THAN COST OF CAPITAL; DO NOT ACCEPT.

PAYBACK:
YEAR
0
1
2
3
4
CASH FLOW
($260.0)
79.7
91.2
62.4
89.7

($260.0)
(180.3)
(89.1)
(26.7)
63.0
PAYBACK = 3 YEARS + $26.7/$89.7 = 3.3 YEARS.

BASED ON THE ANALYSIS TO THIS POINT, THE PROJECT SHOULD
UNDERTAKEN.
HOWEVER,
THIS
MAY
NOT
BE
CORRECT,
AS
WE
NOT BE
WILL
SEE
SHORTLY.
E.
IF THIS PROJECT HAD BEEN A REPLACEMENT RATHER THAN AN EXPANSION

PROJECT,
HOW
WOULD
THE
ANALYSIS
HAVE
CHANGED?
THINK
ABOUT
THE
CHANGES THAT WOULD HAVE TO OCCUR IN THE CASH FLOW TABLE.

ANSWER:
[SHOW S12-18 AND S12-19 HERE.]
IN A REPLACEMENT ANALYSIS, WE MUST
FIND DIFFERENCES IN CASH FLOWS, i.e., THE CASH FLOWS THAT WOULD EXIST
IF WE TAKE ON THE PROJECT VERSUS IF WE DO NOT.
THUS, IN THE TABLE
THERE WOULD NEED TO BE, FOR EACH YEAR, A COLUMN FOR NO CHANGE, A
COLUMN FOR THE NEW PROJECT, AND FOR THE DIFFERENCE.
THE DIFFERENCE
COLUMN IS THE ONE THAT WOULD BE USED TO OBTAIN THE NPV, IRR, ETC.
F.
ASSUME THAT INFLATION IS EXPECTED TO AVERAGE 5 PERCENT OVER THE NEXT

4 YEARS; THAT THIS EXPECTATION IS REFLECTED IN THE WACC; AND THAT
INFLATION WILL INCREASE VARIABLE COSTS AND REVENUES BY THE SAME
PERCENTAGE, 5 PERCENT.
DOES IT APPEAR THAT INFLATION HAS BEEN DEALT
WITH PROPERLY IN THE ANALYSIS?
IF NOT, WHAT SHOULD BE DONE, AND HOW
WOULD THE REQUIRED ADJUSTMENT AFFECT THE DECISION?
YOU CAN MODIFY
THE NUMBERS IN THE TABLE TO QUANTIFY YOUR RESULTS.

ANSWER:
IT IS APPARENT FROM THE DATA IN
THE PREVIOUS TABLE THAT INFLATION HAS NOT BEEN REFLECTED IN THE
CALCULATIONS.
IN PARTICULAR, THE SALES PRICE IS HELD CONSTANT RATHER
THAN RISING WITH INFLATION. THEREFORE, REVENUES AND COSTS (EXCEPT

DEPRECIATION) SHOULD BOTH BE INCREASED BY 5 PERCENT PER YEAR. SINCE
REVENUES ARE LARGER THAN OPERATING COSTS, INFLATION WILL CAUSE CASH
FLOWS TO INCREASE.
THIS WILL LEAD TO A HIGHER NPV, IRR, AND MIRR,
AND TO A SHORTER PAYBACK.
TABLE IC12-2 REFLECTS THE CHANGES, AND IT
SHOWS THE NEW CASH FLOWS AND THE NEW INDICATORS.
WHEN INFLATION IS
PROPERLY ACCOUNTED FOR THE PROJECT IS SEEN TO BE PROFITABLE.

INPUTS:
PRICE:
VC RATE:
$2.00
60.0%
k:
T-RATE:
END OF YEAR:
EQUIPMENT COST
INSTALLATION
10.0%
40%
INFL:
5.0%
100
$2.100
$210.0
100
$2.205
$220.5
100
$2.315
$231.5
100
$2.431
$243.1
$126.0
79.2
$205.2
$ 4.8
1.9
$ 2.9
79.2
$ 82.1
$132.3
108.0
$240.3
($ 19.8)
(7.9)
($ 11.9)
108.0
$ 96.1
$138.9
36.0
$174.9
$ 56.6
22.6
$ 34.0
36.0
$ 70.0
$145.9
16.8
$162.7
$ 80.4
32.1
$ 48.3
16.8
$ 65.1
($200)
(40)
(25)
5
(260)

PRICE/UNIT
TOTAL REVENUES
OPERATING COSTS,
DEPRECIATION
TOTAL COSTS
DEPRECIATION
OPERATING CASH FLOW
$
0.0

SALVAGE VALUE
IV. NET CASH FLOWS
NET CASH FLOW
($260.0)

FOR PAYBACK:
(260.0)
COMPOUNDED INFLOWS FOR MIRR:
TERMINAL VALUE OF INFLOWS:
V. RESULTS
NPV =
$15.0
IRR =
12.6%
MIRR =
11.6%
PAYBACK =
3.1 YEARS
$ 82.1
(177.9)
109.2
20.0
25.0
(10.0)
$ 35.0
$ 96.1
(81.8)
116.3
$ 70.0
(11.8)
77.0
$100.1
88.3
100.1
402.6
ALTHOUGH INFLATION WAS CONSIDERED IN THE INITIAL ANALYSIS, THE RISKINESS OF

THE
PROJECT
WAS
NOT
CONSIDERED.
THE
EXPECTED
CASH
FLOWS,
CONSIDERING
INFLATION (IN THOUSANDS OF DOLLARS), ARE GIVEN IN TABLE IC12-2.
ALLIED'S
OVERALL COST OF CAPITAL (WACC) IS 10 PERCENT.

YEAR
0
INVESTMENT IN:
FIXED ASSETS
NET OPERATING
WORKING CAPITAL
($240)
(20)

SALE PRICE (DOLLARS)
TOTAL REVENUES
CASH OPERATING COSTS (60%)
DEPRECIATION
OPER. INCOME BEFORE TAXES
TAXES ON OPER. INCOME (40%)
OPER. INCOME AFTER TAXES
$ 48.3
PLUS DEPRECIATION
OPERATING CASH FLOW
SALVAGE VALUE
TAX ON SV (40%)
RECOVERY OF NOWC
NET CASH FLOW
CUMULATIVE CASH FLOWS
FOR PAYBACK:
COMPOUNDED INFLOWS
FOR MIRR:
TERMINAL VALUE OF
INFLOWS:
($260)
(260.0)
100
$2.100
$210.0
126.0
79.2
$ 4.8
1.9
$ 2.9
100
$2.205
$220.5
132.3
108.0
($19.8)
(7.9)
($11.9)
100
$2.315
$231.5
138.9
36.0
$ 56.6
22.6
100
$2.431
$243.1
145.9
16.8
$ 80.4
32.1
79.2
$ 82.1
108.0
$ 96.1
36.0
$ 70.0
$ 82.1
$ 96.1
$ 70.0
16.8
$ 65.1
25.0
(10.0)
20.0
$100.1
(177.9)
(81.8)
(11.8)
88.3
109.2
116.3
77.0
100.1
402.6
NPV AT 10% COST OF CAPITAL = $15.0

IRR
= 12.6%
MIRR
= 11.6%
YOU HAVE BEEN ASKED TO ANSWER THE FOLLOWING QUESTIONS.
G.
1. WHAT
ARE
THE
THREE
LEVELS,
OR
TYPES,
OF
PROJECT
RISK
THAT
ARE
NORMALLY CONSIDERED?
ANSWER:

PROJECT RISK:
HERE ARE THE THREE TYPES OF
1. STAND-ALONE RISK IS THE PROJECT'S TOTAL RISK IF IT WERE OPERATED

INDEPENDENTLY.
STAND-ALONE RISK IGNORES BOTH THE FIRM'S DIVER-
SIFICATION AMONG PROJECTS AND INVESTORS' DIVERSIFICATION AMONG

FIRMS.
STAND-ALONE RISK IS MEASURED EITHER BY THE PROJECT'S
STANDARD DEVIATION (NPV) OR ITS COEFFICIENT OF VARIATION OF NPV

(CVNPV).
2. WITHIN-FIRM (CORPORATE) RISK IS THE TOTAL RISKINESS OF THE PROJECT
GIVING
CONSIDERATION
TO
THE
FIRM'S
DIVERSIFICATION WITHIN THE FIRM.
OTHER
PROJECTS,
i.e.,
TO
IT IS THE CONTRIBUTION OF THE
PROJECT TO THE FIRM'S TOTAL RISK, AND IT IS A FUNCTION OF (A) THE

PROJECT'S STANDARD DEVIATION OF NPV AND (2) THE CORRELATION OF THE
PROJECTS' RETURNS WITH THOSE OF THE REST OF THE FIRM.
WITHIN-FIRM
RISK IS OFTEN CALLED CORPORATE RISK, AND IT IS MEASURED BY THE

BETA OF THE PROJECT'S ROA VERSUS THE FIRM'S ROA.
3. MARKET RISK IS THE RISKINESS OF THE PROJECT TO A WELL-DIVERSIFIED
INVESTOR.
AND
IT
THEORETICALLY, IT IS MEASURED BY THE PROJECT'S BETA,

CONSIDERS
BOTH
CORPORATE
RISK
AND
STOCKHOLDER
DIVERSIFICATION.
G.
2. WHICH TYPE IS MOST RELEVANT?
ANSWER:
[SHOW S12-27 HERE.]
BECAUSE MANAGEMENT'S PRIMARY GOAL IS SHAREHOLDER
WEALTH MAXIMIZATION, THE MOST RELEVANT RISK FOR CAPITAL PROJECTS IS

MARKET RISK.
ARE
ALL
INFLUENCE
HOWEVER, CREDITORS, CUSTOMERS, SUPPLIERS, AND EMPLOYEES
AFFECTED
THE
BY
FIRM'S
FIRM'S
TOTAL
PROFITABILITY,
RISK.
SINCE
PROJECT'S
THESE
PARTIES
WITHIN-FIRM
RISK
SHOULD NOT BE COMPLETELY IGNORED.
G.
3. WHICH TYPE IS EASIEST TO MEASURE?
ANSWER:
BY FAR THE EASIEST TYPE OF RISK TO MEASURE IS A PROJECT'S STAND-ALONE

RISK.
THUS, FIRMS OFTEN FOCUS PRIMARILY ON THIS TYPE OF RISK WHEN
MAKING CAPITAL BUDGETING DECISIONS. THIS FOCUS IS NOT THEORETICALLY

CORRECT, BUT IT DOES NOT NECESSARILY LEAD TO POOR DECISIONS, BECAUSE
MOST PROJECTS THAT A FIRM UNDERTAKES ARE IN ITS CORE BUSINESS.
G.
4. ARE THE THREE TYPES OF RISK GENERALLY HIGHLY CORRELATED?
ANSWER:
[SHOW S12-28 HERE.]
BECAUSE MOST PROJECTS THAT A FIRM UNDERTAKES ARE
IN ITS CORE BUSINESS, A PROJECT'S STAND-ALONE RISK IS LIKELY TO BE

HIGHLY CORRELATED WITH ITS CORPORATE RISK, WHICH IN TURN IS LIKELY TO
BE HIGHLY CORRELATED WITH ITS MARKET RISK.
H.
1. WHAT IS SENSITIVITY ANALYSIS?
ANSWER:
[SHOW S12-29 HERE.]
SENSITIVITY ANALYSIS MEASURES THE EFFECT OF
CHANGES IN A PARTICULAR VARIABLE, SAY REVENUES, ON A PROJECT'S NPV.

TO PERFORM A SENSITIVITY ANALYSIS, ALL VARIABLES ARE FIXED AT THEIR
EXPECTED VALUES EXCEPT ONE.
THIS ONE VARIABLE IS THEN CHANGED, OFTEN
BY SPECIFIED PERCENTAGES, AND THE RESULTING EFFECT ON NPV IS NOTED.

(ONE COULD ALLOW MORE THAN ONE VARIABLE TO CHANGE, BUT THIS THEN
MERGES SENSITIVITY ANALYSIS INTO SCENARIO ANALYSIS.)
H.
2. DISCUSS HOW ONE WOULD PERFORM A SENSITIVITY ANALYSIS ON THE UNIT

SALES, SALVAGE VALUE, AND COST OF CAPITAL FOR THE PROJECT.
THAT
EACH
OF
THESE
VARIABLES
DEVIATES
FROM
ITS
ASSUME
BASE-CASE,
EXPECTED, VALUE BY PLUS AND MINUS 10, 20, AND 30 PERCENT.
OR
EXPLAIN
HOW YOU WOULD CALCULATE THE NPV, IRR, MIRR, AND PAYBACK FOR EACH
CASE.
ANSWER:
THE BASE CASE VALUE FOR UNIT SALES WAS 100; THEREFORE, IF YOU WERE TO
ASSUME THAT THIS VALUE DEVIATED BY PLUS AND MINUS 10, 20, AND 30
PERCENT, THE UNIT SALES VALUES TO BE USED IN THE SENSITIVITY ANALYSIS
WOULD BE 70, 80, 90, 110, 120, AND 130 UNITS.
YOU WOULD THEN GO BACK
TO THE TABLE AT THE BEGINNING OF THE PROBLEM, INSERT THE APPROPRIATE

SALES UNIT NUMBER, SAY 70 UNITS, AND REWORK THE TABLE FOR THE CHANGE
IN SALES UNITS ARRIVING AT DIFFERENT NET CASH FLOW VALUES FOR THE
PROJECT.
ONCE YOU HAD THE NET CASH FLOW VALUES, YOU WOULD CALCULATE
THE NPV, IRR, MIRR, AND PAYBACK AS YOU DID PREVIOUSLY.
(NOTE THAT
SENSITIVITY ANALYSIS INVOLVES MAKING A CHANGE TO ONLY ONE VARIABLE TO

SEE HOW IT IMPACTS OTHER VARIABLES.)
THEN, YOU WOULD GO BACK AND
REPEAT THE SAME STEPS FOR 80 UNITS--THIS WOULD BE DONE FOR EACH OF
THE SALES UNIT VALUES. THEN, YOU WOULD REPEAT THE SAME PROCEDURE FOR
THE SENSITIVITY ANALYSIS ON SALVAGE VALUE AND ON COST OF CAPITAL.

(NOTE THAT FOR THE COST OF CAPITAL ANALYSIS, THE NET CASH FLOWS WOULD
REMAIN THE SAME, BUT THE COST OF CAPITAL USED IN THE NPV AND MIRR
CALCULATIONS WOULD BE DIFFERENT.)
EXCEL AND LOTUS 1-2-3 ARE IDEALLY SUITED FOR SENSITIVITY ANALYSIS.
IN FACT WE CREATED A SPREADSHEET TO OBTAIN THIS PROJECTS' NET CASH
FLOWS AND ITS NPV, IRR, MIRR, AND PAYBACK.
ONCE A MODEL HAS BEEN
CREATED, IT IS VERY EASY TO CHANGE THE VALUES OF VARIABLES AND OBTAIN

THE NEW RESULTS.
THE RESULTS OF THE SENSITIVITY ANALYSIS ON THE
PROJECT'S NPV ASSUMING THE PLUS AND MINUS 10, 20, AND 30 PERCENT
DEVIATIONS ARE SHOWN BELOW.
WE GENERATED THESE DATA WITH A SPREADSHEET MODEL.
1. THE SENSITIVITY LINES INTERSECT AT 0% CHANGE AND THE BASE CASE
NPV, AT APPROXIMATELY $15,000.
SINCE ALL OTHER VARIABLES ARE SET
AT THEIR BASE CASE, OR EXPECTED, VALUES, THE ZERO CHANGE SITUATION

IS THE BASE CASE.
2. THE PLOTS FOR UNIT SALES AND SALVAGE VALUE ARE UPWARD SLOPING,
INDICATING
THAT
HIGHER
VARIABLE
VALUES
LEAD
TO
HIGHER
NPVs.
CONVERSELY, THE PLOT FOR COST OF CAPITAL IS DOWNWARD SLOPING,

BECAUSE A HIGHER COST OF CAPITAL LEADS TO A LOWER NPV.
3. THE PLOT OF UNIT SALES IS MUCH STEEPER THAN THAT FOR SALVAGE
VALUE. THIS INDICATES THAT NPV IS MORE SENSITIVE TO CHANGES IN
UNIT SALES THAN TO CHANGES IN SALVAGE VALUE.
4. STEEPER
SENSITIVITY
COMPARING
TWO
LINES
PROJECTS,
CONSIDERED TO BE RISKIER.
INDICATE
THE
ONE
GREATER
WITH
THE
RISK.
THUS,
IN
STEEPER
LINES
IS
Sensitivity Graph
NPV
(Thousands)
70
60
Unit Sales
50
40
30
20
10
Salvage Value
Cost of Capital
-10
-20
-30
-40
-30%
-20%
-10%
0%
10%
20%
30%
THE SENSITIVITY DATA ARE GIVEN HERE IN TABULAR FORM (IN THOUSANDS OF
DOLLARS):
CHANGE FROM
BASE LEVEL
-30%
-20
-10
0
+10
+20
+30
H.
RESULTING NPV AFTER THE INDICATED CHANGE IN:

UNIT SALES
SALVAGE VALUE
k
($36.4)
$11.9
$34.1
(19.3)
12.9
27.5
(2.1)
13.9
21.1
15.0
15.0
15.0
32.1
16.0
9.0
49.2
17.0
3.3
66.3
18.0
(2.2)
3. WHAT IS THE PRIMARY WEAKNESS OF SENSITIVITY ANALYSIS?
WHAT ARE ITS
PRIMARY ADVANTAGES?
ANSWER:
THE TWO PRIMARY DISADVANTAGES OF
SENSITIVITY ANALYSIS ARE (1) THAT IT DOES NOT REFLECT THE EFFECTS OF
DIVERSIFICATION AND (2) THAT IT DOES NOT INCORPORATE ANY INFORMATION
ABOUT
THE
POSSIBLE
MAGNITUDES
OF
THE
FORECAST
ERRORS.
THUS,
SENSITIVITY ANALYSIS MIGHT INDICATE THAT A PROJECT'S NPV IS HIGHLY

SENSITIVE TO THE SALES FORECAST, HENCE THAT THE PROJECT IS QUITE
RISKY, BUT IF THE PROJECT'S SALES, HENCE ITS REVENUES, ARE FIXED BY A
LONG-TERM CONTRACT, THEN SALES VARIATIONS MAY ACTUALLY CONTRIBUTE
LITTLE TO THE PROJECT'S RISK.
THEREFORE,
IN
MANY
SITUATIONS,
SENSITIVITY
PARTICULARLY GOOD INDICATOR OF RISK.
ANALYSIS
IS
NOT
HOWEVER, SENSITIVITY ANALYSIS
DOES IDENTIFY THOSE VARIABLES THAT POTENTIALLY HAVE THE GREATEST

IMPACT
ON
PROFITABILITY,
AND
THIS
HELPS
MANAGEMENT
FOCUS
ITS
ATTENTION ON THOSE VARIABLES THAT ARE PROBABLY MOST IMPORTANT.
I.
ASSUME
THAT
YOU
ARE
CONFIDENT
ABOUT
THE
ESTIMATES
VARIABLES THAT AFFECT THE CASH FLOWS EXCEPT UNIT SALES.
OF
ALL
THE
IF PRODUCT
ACCEPTANCE IS POOR, SALES WOULD BE ONLY 75,000 UNITS A YEAR, WHILE A

STRONG CONSUMER RESPONSE WOULD PRODUCE SALES OF 125,000 UNITS.
IN
EITHER CASE, CASH COSTS WOULD STILL AMOUNT TO 60 PERCENT OF REVENUES.

YOU BELIEVE 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 THE WORST-CASE NPV?
ANSWER:
THE BEST-CASE NPV?
WE USED A SPREADSHEET MODEL TO
DEVELOP THE SCENARIOS (IN THOUSANDS OF DOLLARS), WHICH ARE SUMMARIZED

BELOW:
CASE
WORST
BASE
BEST
I.
PROBABILITY
0.25
0.50
0.25
NPV (000s)
($27.8)
15.0
57.8
2. USE THE WORST-, MOST LIKELY (OR BASE), AND BEST-CASE NPVs, WITH THEIR
PROBABILITIES OF OCCURRENCE, TO FIND THE PROJECT'S EXPECTED NPV,
STANDARD DEVIATION, AND COEFFICIENT OF VARIATION.
ANSWER:
[SHOW S12-34 HERE.]
THE EXPECTED NPV IS $14,968 (ROUNDED TO THE
NEAREST THOUSAND BELOW).

E(NPV) = 0.25(-$27.8) + 0.50($15.0) + 0.25($57.8) = $15.
THE STANDARD DEVIATION OF NPV IS $30.3:
NPV = [0.25(-$27.8 - $15)2 + 0.50($15 - $15)2 + 0.25($57.8 - $15)2]1/2
= [916]1/2 = $30.3,
AND THE PROJECT'S COEFFICIENT OF VARIATION IS 2.0:

CVNPV =
J.
NPV
$30.3
2.0.
E(NPV)
$15
1. ASSUME THAT ALLIED'S AVERAGE PROJECT HAS A COEFFICIENT OF VARIATION

(CV) IN THE RANGE OF 1.25 TO 1.75.
WOULD THE LEMON JUICE PROJECT BE
CLASSIFIED AS HIGH RISK, AVERAGE RISK, OR LOW RISK?
WHAT TYPE OF
RISK IS BEING MEASURED HERE?

ANSWER:
[SHOW S12-35 HERE.]
THE PROJECT HAS A CV OF 2.0, WHICH IS MUCH
HIGHER THAN THE AVERAGE RANGE OF 1.25 TO 1.75, SO IT FALLS INTO THE
HIGH-RISK CATEGORY.
THE CV MEASURES A PROJECT'S STAND-ALONE RISK--IT
IS MERELY A MEASURE OF THE VARIABILITY OF RETURNS (AS MEASURED BY

NPV) ABOUT THE EXPECTED RETURN.
J.
2. BASED ON COMMON SENSE, HOW HIGHLY CORRELATED DO YOU THINK THE PROJECT
WOULD
BE
WITH
THE
FIRM'S
OTHER
ASSETS?
(GIVE
CORRELATION
COEFFICIENT, OR RANGE OF COEFFICIENTS, BASED ON YOUR JUDGMENT.)

ANSWER:
[SHOW S12-36 HERE.]
IT IS REASONABLE TO ASSUME THAT IF THE ECONOMY
IS STRONG AND PEOPLE ARE BUYING A LOT OF LEMON JUICE, THEN SALES
WOULD BE STRONG IN ALL OF THE COMPANY'S LINES, SO THERE WOULD BE
POSITIVE
CORRELATION
BETWEEN
THIS
PROJECT
AND
THE
REST
OF
THE
BUSINESS. HOWEVER, EACH LINE COULD BE MORE OR LESS SUCCESSFUL, SO THE

CORRELATION WOULD BE LESS THAN +1.0.
A REASONABLE GUESS MIGHT BE
+0.7, OR WITHIN A RANGE OF +0.5 TO +0.9.
J.
3. HOW WOULD THIS CORRELATION COEFFICIENT AND THE PREVIOUSLY CALCULATED
COMBINE TO AFFECT THE PROJECT'S CONTRIBUTION TO CORPORATE, OR
WITHIN-FIRM, RISK?
ANSWER:
EXPLAIN.
IF THE PROJECT'S CASH FLOWS ARE LIKELY TO BE HIGHLY CORRELATED WITH

THE FIRM'S AGGREGATE CASH FLOWS, WHICH IS GENERALLY A REASONABLE
ASSUMPTION,
THEN
THE
PROJECT
WOULD
HAVE
HIGH
CORPORATE
RISK.
HOWEVER, IF THE PROJECT'S CASH FLOWS WERE EXPECTED TO BE TOTALLY
UNCORRELATED WITH THE FIRM'S AGGREGATE CASH FLOWS, OR POSITIVELY

CORRELATED
BUT
LESS
THAN
PERFECTLY
POSITIVELY
CORRELATED,
THEN
ACCEPTING THE PROJECT WOULD REDUCE THE FIRM'S TOTAL RISK, AND IN THAT
CASE, THE RISKINESS OF THE PROJECT WOULD BE LESS THAN SUGGESTED BY
ITS STAND-ALONE RISK.
IF THE PROJECT'S CASH FLOWS WERE EXPECTED TO
BE NEGATIVELY CORRELATED WITH THE FIRM'S AGGREGATE CASH FLOWS, THEN

THE PROJECT WOULD REDUCE THE TOTAL RISK OF THE FIRM EVEN MORE.
K.
1. BASED ON YOUR JUDGMENT, WHAT DO YOU THINK THE PROJECT'S CORRELATION

COEFFICIENT WOULD BE WITH RESPECT TO THE GENERAL ECONOMY AND THUS
WITH RETURNS ON "THE MARKET"?
ANSWER:
IN ALL LIKELIHOOD, THIS PROJECT WOULD HAVE A POSITIVE CORRELATION

WITH RETURNS ON OTHER ASSETS IN THE ECONOMY, AND SPECIFICALLY WITH
THE STOCK MARKET.
ALLIED FOOD PRODUCTS PRODUCES FOOD ITEMS, AND SUCH
FIRMS TEND TO HAVE LESS RISK THAN THE ECONOMY AS A WHOLE--PEOPLE MUST
EAT REGARDLESS OF THE NATIONAL ECONOMIC SITUATION.
HOWEVER, PEOPLE
WOULD TEND TO SPEND MORE ON NON-ESSENTIAL TYPES OF FOOD WHEN THE

ECONOMY
IS
GOOD
AND
TO
CUT
BACK
WHEN
THE
ECONOMY
IS
WEAK.
REASONABLE GUESS MIGHT BE +0.7, OR WITHIN A RANGE OF +0.5 TO +0.9.
K.
2. HOW WOULD CORRELATION WITH THE ECONOMY AFFECT THE PROJECT'S MARKET
RISK?
ANSWER:
[SHOW S12-37 HERE.]
THIS CORRELATION WOULD NOT DIRECTLY AFFECT THE
PROJECT'S
RISK,
CORPORATE
BUT
IT
DOES,
WHEN
COMBINED
WITH
THE
PROJECT'S HIGH STAND-ALONE RISK, SUGGEST THAT THE PROJECT'S MARKET

RISK AS MEASURED BY ITS MARKET BETA IS RELATIVELY HIGH.
L.
1. ALLIED TYPICALLY ADDS OR SUBTRACTS 3 PERCENTAGE POINTS TO THE OVERALL

COST OF CAPITAL TO ADJUST FOR RISK.
SHOULD THE LEMON JUICE PROJECT
BE ACCEPTED?
ANSWER:
SINCE THE PROJECT IS JUDGED TO HAVE
ABOVE-AVERAGE RISK, ITS DIFFERENTIAL RISK-ADJUSTED, OR PROJECT, COST

OF CAPITAL WOULD BE 13 PERCENT.
AT THIS DISCOUNT RATE, ITS NPV WOULD
BE -$2,226, SO IT WOULD NOT BE ACCEPTABLE.
IF IT WERE A LOW-RISK
PROJECT, ITS COST OF CAPITAL WOULD BE 7 PERCENT, ITS NPV WOULD BE

$34,117, AND IT WOULD BE A PROFITABLE PROJECT ON A RISK-ADJUSTED
BASIS.
L.
2. WHAT SUBJECTIVE RISK FACTORS SHOULD BE CONSIDERED BEFORE THE FINAL

DECISION IS MADE?
ANSWER:
A NUMERICAL ANALYSIS SUCH AS THIS ONE MAY NOT CAPTURE ALL OF THE RISK
FACTORS INHERENT IN THE PROJECT.
IF THE PROJECT HAS A POTENTIAL FOR
BRINGING ON HARMFUL LAWSUITS, THEN IT MIGHT BE RISKIER THAN FIRST

ASSESSED.
ALSO, IF THE PROJECT'S ASSETS CAN BE REDEPLOYED WITHIN THE
FIRM OR CAN BE EASILY SOLD, THEN THE PROJECT MAY BE LESS RISKY THAN
THE ANALYSIS INDICATES.
SOLUTION TO APPENDIX 12A PROBLEM
12A-1 Year
0
1
2
3
4
5
6
7
8
9
10
11
MACRS
Dep
S-L Dep
T(Dep)
0
0
2,800,000
1,400,000
700,000
(350,000)
(1,050,000)
(1,050,000)
(1,050,000)
(1,050,000)
(1,400,000)
1,050,000
$1,310,841
$
$10,000,000
18,000,000
14,000,000
12,000,000
9,000,000
7,000,000
7,000,000
7,000,000
7,000,000
6,000,000
3,000,000
$10,000,000
10,000,000
10,000,000
10,000,000
10,000,000
10,000,000
10,000,000
10,000,000
10,000,000
10,000,000
0
0
8,000,000
4,000,000
2,000,000
(1,000,000)
(3,000,000)
(3,000,000)
(3,000,000)
(3,000,000)
(4,000,000)
3,000,000
PV @ 9% =
Therefore, the value of the firm would be increased by $1,310,841, each

year, if it elected to use standard MACRS depreciation rates.
The Dryden Press
Solutions to Appendix Problems: 12 - 31

Solutions To End-Of-Chapter Problems: - 17 - 1 0.00 $18,540,00 7.59 $21,750,22 E (NPV) CV

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Chapter 12

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

Operating Cash Flows: t = 1

Equipments original cost

Gain on sale = $5,000,000 - $4,000,000 = $1,000,000.

Expected NPV = (0.3)(-$10,800) + (0.5)($23,400) + (0.2)($50,400)

Answers and Solutions: 12 - 1

E(NPV) = 0.05(-$70) + 0.20(-$25) + 0.50($12) + 0.20($20) + 0.05($30)

$ 90,000 $ 90,000 $ 90,000

Beg. Bk. Value

Answers and Solutions: 12 - 2

(1) Savings increase by 20%:

$108,000 $108,000 $108,000

Answers and Solutions: 12 - 3

$108,000 $108,000 $108,000

NPV = [(0.35)(-$7,663.52 - $34,800.21)2 + (0.35)($37,035.13 $34,800.21)2 + (0.30)($81,733.79 - $34,800.21)2]

a. The net cost is $178,000:

b. The operating cash flows follow:

Answers and Solutions: 12 - 4

Remaining BV in Year 4 = $170,000(0.07) = $11,900.

Net Cash Flow

Alternatively, place the cash flows on a time line:

With a financial calculator, input the appropriate cash flows into

a. The net cost is $126,000:

Answers and Solutions: 12 - 5

b. The operating cash flows follow:

BV in Year 4 = $120,500(0.07) = $8,435.

Net Cash Flow

Alternatively, place the cash flows on a time line:

With a financial calculator, input the appropriate cash flows into

Answers and Solutions: 12 - 6

a. Expected annual cash flows:

($750)2(0.2) ($0)2(0.6) ($750)2(0.2) $474.34.

CVA = $474.34/$6,750 = 0.0703.

Project B is the riskier project because it has the greater variability

= $6,750(PVIFA10%,3) - $6,750 = $6,750(2.4869) - $6,750

Alternatively, with a financial calculator, input the appropriate cash

= $7,650(PVIFA12%,3) - $6,750 = $7,650(2.4018) - $6,750

Alternatively, with a financial calculator, input the appropriate cash

Answers and Solutions: 12 - 7

12-10 If actual life is 5 years:

NPV = PV(Inflows) - PV(Outflows) = $38,212 - $36,000 = $2,212.

Answers and Solutions: 12 - 8

NPV = $33,919 - $36,000 = -$2,081.

NPV = $49,329 - $36,000 = $13,329.

Answers and Solutions: 12 - 9

12-12 The detailed solution for the cyberproblem is available on the

Harcourt, Inc. items and derived items copyright 2000 by

Allied Food Products

ASSUME THAT YOU WERE

RECENTLY HIRED AS ASSISTANT TO THE DIRECTOR OF CAPITAL BUDGETING, AND

THE REQUIRED EQUIPMENT WOULD COST $200,000, PLUS

AN ADDITIONAL $40,000 FOR SHIPPING AND INSTALLATION.

INVENTORIES WOULD RISE BY $25,000, WHILE ACCOUNTS PAYABLE WOULD GO UP

ALL OF THESE COSTS WOULD BE INCURRED AT t = 0. BY A

SPECIAL RULING, THE MACHINERY COULD BE DEPRECIATED UNDER THE MACRS

THE CASH INFLOWS ARE ASSUMED TO BEGIN 1 YEAR

AFTER THE PROJECT IS UNDERTAKEN, OR AT t = 1, AND TO CONTINUE OUT TO

CASH OPERATING COSTS FOR THE

PROJECT (TOTAL OPERATING COSTS LESS DEPRECIATION) ARE EXPECTED TO

ALLIEDS TAX RATE IS 40 PERCENT,

AND ITS WEIGHTED AVERAGE COST OF CAPITAL IS 10 PERCENT.

THE LEMON JUICE PROJECT IS ASSUMED TO BE OF EQUAL RISK TO ALLIEDS