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IOW
Capital Budgeting Analysis
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1. Calculate and provide the annual sales revenues and costs (other than depreciation). Why
is it important to include inflation when estimating cash flows?

2. Construct 4 years of annual incremental operating cash flow statements for IOW Casting
Company. Estimate the required net working capital for each year, and the cash flow due
to investments in net working capital. Calculate the after-tax salvage cash flow.

3. Calculate the net cash flows for each of the 4 years. Based on these cash flows, what are
the project’s NPV, IRR, MIRR, PI, payback, and discounted payback? Do these
indicators suggest the project should be undertaken? Explain.

4. What does the term “risk” mean in the context of capital budgeting? To what extent can
risk be quantified, and, when risk is quantified, is the quantification based primarily on
statistical analysis of historical data or on subjective, judgmental estimates? Provide your
rationale.

5. Describes sensitivity analysis and discuss a) its primary weakness; and b) its primary
usefulness? For the IOW project, perform a sensitivity analysis on the unit sales, salvage
value, and cost of capital. Assume that each of these variables can vary from its expected,
or “base-case” value by ± 10%, ± 20%, and ± 30%. Include a sensitivity diagram, and
discuss the results.

6. Assume that Sydney Johnson is confident of her estimates of all the variables that affect
the project’s cash flows except unit sales and sales price. If product acceptance is poor,
unit sales could be only approximately 1,000 units a year and the unit price would be set
at $150. Conversely, an excellent consumer response could produce sales of 2,000 units
and a unit price of $220. Sidney believes that there is a 25% chance of poor acceptance, a
25% chance of excellent acceptance, and a 50% chance of average acceptance (the base
case). What is the worst-case NPV? The best-case NPV? Use the worst-, base-, and best-
case NPVs and probabilities of occurrence to find the project’s expected NPV, standard
deviation, and coefficient of variation.

7. Explain scenario analysis and any problems, issues, or concerns that surround this type of
projection.

8. Define simulation analysis, and discuss its principal advantages and disadvantages.

9. Assume that IOW’s average project has a coefficient of variation in the range of 0.2 to
0.4. Would the new product line be classified as high risk, average risk, or low risk?
What type of risk is being measured here?

10. IOW typically adds or subtracts 5 percentage points to the overall cost of capital to adjust
for risk. Given this consideration, should the new line be accepted? Explain.

11. Describe other subjective risk factors that should be considered before the final decision
is made, and their individual impact on the project.