Chapter 5

Risk Analysis in Capital Budgeting

Problem 1
page 140
Info:
Bethlehem Steel
Current sales level
variable costs
Fixed costs

$2.5 billion
2.0 billion
400 million

Current pre-tax profit

2,500,000,000
2,000,000,000
400,000,000
100,000,000

If sales rise 15%, how much will pretax profit increase in dollar terms?
$2,500,000,000.0
15% increase in sales
2,875,000,000
15% increase in variable costs
2,300,000,000
Fixed costs
400,000,000
$175,000,000
What will be the % increase in pre-tax profit?
$175,000,000
100,000,000
75,000,000
75% increase
What explains the relationship between the % change in sales & the % change
in pre-tax profit?
The effects of operating leverage

Chapter 5
Risk Analysis in Capital Budgeting
Problem 2
page 140
Breakeven quantity
Info:
Boeing Co.
Investment in Boeing 777 airplane
4,000,000,000
Price/plane
120,000,000

per year for 4 yrs

PV of tax w/o
750,000,000
fixed costs per year
100,000,000
variable production costs
90,000,000 per plane
tax rate
34%
discount rate
14%
Life of the plane
15 years
What is break-even quantity?
CF's (in & out), occur at the end of the year

PVIFA 14, 15

6.1422

Breakeven Analysis
To calculate the actual breakeven point:
I0 - D
Q= PVIFAr,n (P-V)(1-t)

I0 Initial Investment

4,000,000,000.00
D PV of Depr w/o & ITC 750,000,000.00
Q annual sales
P unit sales price
120,000,000.00
V unit variable cost
90,000,000.00
F annual fixed cost
100,000,000.00
t tax rate
34%
n project life
15.00
r discount rate
14%
3.25
0.12161556
26.72

F
P-V
4.00 1,000,000,000.00
0.75
0.12
0.09
0.10
34%

0.10
0.03
3.33

30.06 breakeven quantity

Chapter 5
Risk Analysis in Capital Budgeting
Problem 5
page 140-141
Info:
American Fruit Co. constructing new plant
1 plant is capital intensive, other plant is labor intensive

Fixed cost
Variable cost (per unit)
Price (per unit)
Investment

Plant 1
$200,000
1.50
2.00
1,000,000

parts a & b

Plant 2
$600,000
0.50
2.00
1,000,000

a). Calculate the break-even point in units of production for the 2 plants
Q=
Plant 1

400,000

Q=
Plant 2

400,000

b). 3 sales scenarios

Recession
# of units (given)
Plant 1
sales
VC
Subtotal
FC
Return
ROA

$200,000
0.50
F
(P - V)
$600,000
1.50

Normal

300,000

500,000

600,000
(450,000)
150,000
(200,000)
(50,000)
-5%

1,000,000
(750,000)
250,000
(200,000)
50,000
5%

Recession
300,000
Plant 2
sales
VC
Subtotal
FC
Return
ROA

F
(P - V)

600,000
(150,000)
450,000
(600,000)
(150,000)
-15%

Normal
500,000
1,000,000
(250,000)
750,000
(600,000)
150,000
15%

Recovery Calc the return on assets for the 2 plants under the 3 scenarios
800,000 ROA = Return/Investment
1,600,000
(1,200,000)
400,000
(200,000)
200,000
20%

Recovery
800,000
1,600,000
(400,000)
1,200,000
(600,000)
600,000
60%

Chapter 5
Risk Analysis in Capital Budgeting
Problem 6
page 141
Info:
Prepared a set of certainty-equivalent factors
to adjust the CF's for the estimated risk
Prepared a set of risk adjusted interest rates
Initial investment
$150,000
rate
8%
Year
Cash Flows (000's)
Certainty equivalents (finance dept)
Risk adjusted rates (economicsdept)

2
50
0.982
10%

75
0.964
12%

3
130
0.947
14%

a). What is the NPV of the project using the finance dept's estimates?
CF's x certainty equivalents
49.1
72.3
123.11

b). What is the NPV of the project using the economic's dept's estimates?
Cash Flows (000's)
50
75
130
Risk adjusted rates (economicsdept)
10%
12%
14%

$205.18 NPV
(150) initial investment
$55.18 (000's)
55,177

$1.10
$45.45

c). What would you advise the company to do?

Accept the project as positive NPV

1.12^2
$59.79

1.14^3
$87.75

$192.99
(150)
$42.99 (000's)
42,990