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12/7/2012

Chapter:
Problem:

11
18

Webmasters.com has developed a powerful new server that would be used for corporations Internet activities. It
would cost $10 million at Year 0 to buy the equipment necessary to manufacture the server. The project would
require net working capital at the beginning of each year in an amount equal to 10% of the year's projected sales; for
example, NWC0 = 10%(Sales1). The servers would sell for $24,000 per unit, and Webmasters believes that variable
costs would amount to $17,500 per unit. After Year 1, the sales price and variable costs will increase at the inflation
rate of 3%. The companys nonvariable costs would be $1 million at Year 1 and would increase with inflation.

The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4
years. Also, the project's returns are expected to be highly correlated with returns on the firm's other assets. The
firm believes it could sell 1,000 units per year.

The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of the
equipment at the end of the projects 4-year life is $500,000. Webmasters federal-plus-state tax rate is 40%. Its cost
of capital is 10% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 and
1.2. Low-risk projects are evaluated with a WACC of 8%, and high-risk projects at 13%.
a. Develop a spreadsheet model, and use it to find the projects NPV, IRR, and payback.
Input Data (in thousands of dollars)
Equipment cost
Net operating working capital/Sales
First year sales (in units)
Sales price per unit
Variable cost per unit (excl. depr.)
Nonvariable costs (excl. depr.)
Market value of equipment at Year 4
Tax rate
WACC
Inflation in prices and costs
Estimated salvage value at year 4

$10,000
10%
1,000
$24.00
$17.50
$1,000
$500
40%
10%
3.0%
$500

Intermediate Calculations
Units sold
Sales price per unit (excl. depr.)
Variable costs per unit (excl. depr.)
Nonvariable costs (excl. depr.)
Sales revenue
Required level of net operating working capital
Basis for depreciation
Annual equipment depr. rate
Annual depreciation expense
Ending Bk Val: Cost Accum Dep'rn
Salvage value
Profit (or loss) on salvage

Key Results:
NPV =
IRR =
Payback =

20.00%

32.00%

19.20%

11.52%

$10,000
$10,000
$500

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Tax on profit (or loss)


Net cash flow due to salvage
Cash Flow Forecast
Sales revenue
Variable costs
Nonvariable operating costs
Depreciation (equipment)
Oper. income before taxes (EBIT)
Taxes on operating income (40%)
Net operating profit after taxes
Add back depreciation
Equipment purchases
Cash flow due to change in NOWC
Net cash flow due to salvage
Net Cash Flow (Time line of cash flows)

Years
2

Years
2

Key Results: Appraisal of the Proposed Project


Net Present Value (at 10%) =
IRR =
MIRR =
Payback =
Data for Payback Years
Net cash flow
Cumulative CF
Part of year required for payback

b. Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable
costs per unit, and number of units sold. Set these variables values at 10% and 20% above and below their basecase values. Include a graph in your analysis.
% Deviation
from
Base Case
-20%
-10%
0%
10%
20%

SALES PRICE
Base
NPV
$24.00

% Deviation
from
Base Case
-20%
-10%
0%

VARIABLE COST
Base
NPV
$17.50

10%

Note about data tables. The data in the column input should
NOT be input using a cell reference to the column input cell.
For example, the base case Sales Price in Cell B86 should be
the number $24.00 you should NOT have the formula =D28 in
that cell. This is because you'll use D28 as the column input
cell in the data table and if Excel tries to iteratively replace Cell
D28 with the formula =D28 rather than a series of numbers,
Excel will calculate the wrong answer. Unfortunately, Excel
won't tell you that there is a problem, so you'll just get the
wrong values for the data table!
% Deviation
from
Base Case
-20%
-10%
0%
10%

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1st YEAR UNIT SALES


Base
NPV
1,000

20%

20%

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Deviation NPV at Different Deviations from Base


from
Sales
Variable
Base Case
Price
Cost/Unit Units Sold
-20%
$0
$0
$0
-10%
$0
$0
$0
0%
$0
$0
$0
10%
$0
$0
$0
20%
$0
$0
$0
Range

c. Now conduct a scenario analysis. Assume that there is a 25% probability that best-case conditions, with each of
the variables discussed in Part b being 20% better than its base-case value, will occur. There is a 25% probability of
worst-case conditions, with the variables 20% worse than base, and a 50% probability of base-case conditions.

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Scenario
Best Case
Base Case
Worst Case

Probability

Sales
Price

Unit
Sales

Variable
Costs

25%
50%
25%

$28.80
$24.00
$19.20

1,200
1,000
800

$14.00
$17.50
$21.00

NPV

Expected NPV =
Standard Deviation =
Coefficient of Variation = Std Dev / Expected NPV =

d. If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and
payback.
CV range of firm's average-risk project:
Low-risk WACC =
8%
WACC =
10%
High-risk WACC =
13%

0.8

to

1.2

Risk-adjusted WACC =
Risk adjusted NPV =
IRR =
Payback =
e. On the basis of information in the problem, would you recommend that the project be accepted?

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1,000
$24.00
$17.50

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