Financial management paper 3

Build a Model

Solution								8/13/15		Note: when creating student version, be sure to delete Scenario Summary worksheet. Also delete the Best and Worse case scenarios from the Scenario Manager. Also delete this message in the student version.
Chapter:	11	Estimating Cash Flows and Analyzing Risk
Problem:	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 company’s 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 project’s 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 project’s NPV, IRR, and payback.
Input Data (in thousands of dollars)
Equipment cost			$10,000		Key Results:
Net operating working capital/Sales			10%		NPV =	$3,463
First year sales (in units)			1,000		IRR =	21.1%
Sales price per unit			$24.00		Payback =	2.90
Variable cost per unit (excl. depr.)			$17.50
Nonvariable costs (excl. depr.)			$1,000
Market value of equipment at Year 4			$500
Tax rate			40%
WACC			10%
Inflation in prices and costs			3.0%
Estimated salvage value at year 4			$500
Intermediate Calculations				0	1	2	3	4
Units sold					1,000	1,000	1,000	1,000
Sales price per unit (excl. depr.)					$24.00	$24.72	$25.46	$26.23
Variable costs per unit (excl. depr.)					$17.50	$18.03	$18.57	$19.12
Nonvariable costs (excl. depr.)					1,000	1,030	1,061	1,093
Sales revenue					$24,000	$24,720	$25,462	$26,225
Required level of net operating working capital				$2,400	$2,472	$2,546	$2,623	$0
Basis for depreciation				$10,000
Annual equipment depr. rate					20.00%	32.00%	19.20%	11.52%
Annual depreciation expense					$2,000	$3,200	$1,920	$1,152
Ending Bk Val: Cost – Accum Dep'rn				$10,000	$8,000	$4,800	$2,880	$1,728
Salvage value								$500
Profit (or loss) on salvage								-$1,228
Tax on profit (or loss)								-$491
Net cash flow due to salvage								$991
				Years
Cash Flow Forecast				0	1	2	3	4
Sales revenue					$24,000	$24,720	$25,462	$26,225
Variable costs					17,500	18,025	18,566	19,123
Nonvariable operating costs					1,000	1,030	1,061	1,093
Depreciation (equipment)					2,000	3,200	1,920	1,152
Oper. income before taxes (EBIT)					$3,500	$2,465	$3,915	$4,858
Taxes on operating income (40%)					1,400	986	1,566	1,943
Net operating profit after taxes					$2,100	$1,479	$2,349	$2,915
Add back depreciation					2,000	3,200	1,920	1,152
Equipment purchases				-$10,000
Cash flow due to change in NOWC				-$2,400	-$72	-$74	-$76	$2,623
Net cash flow due to salvage								$991
Net Cash Flow (Time line of cash flows)				-$12,400	$4,028	$4,605	$4,193	$7,681
Key Results: Appraisal of the Proposed Project
Net Present Value (at 10%) =			$3,463
IRR =			21.09%
MIRR =			16.99%
Payback =			2.90
Discounted Payback =			3.23
Data for Payback Years				Years
				0	1	2	3	4
			Net cash flow	-$12,400	$4,028	$4,605	$4,193	$7,681
			Cumulative CF	-$12,400	-$8,372	-$3,767	$425	$8,106
			Part of year required for payback		1.00	1.00	0.90	0.00
Data for Discounted Payback Years				Years
				0	1	2	3	4
			Net cash flow	-$12,400	$4,028	$4,605	$4,193	$7,681
			Discounted cash flow	-$12,400	$3,662	$3,806	$3,150	$5,246
			Cumulative CF	-$12,400	-$8,738	-$4,933	-$1,783	$3,463
			Part of year required for discounted payback		1.00	1.00	1.00	0.23
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 base-case values. Include a graph in your analysis.
% Deviation	SALES PRICE			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 B95 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!
from	Base	NPV
Base Case	$24.00	$3,463
-20%	$19.20	-$5,893
-10%	$21.60	-$1,215
0%	$24.00	$3,463
10%	$26.40	$8,141
20%	$28.80	$12,820
% Deviation	VARIABLE COST			% Deviation	1st YEAR UNIT SALES
from	Base	NPV		from	Base	NPV
Base Case	$17.50	$3,463		Base Case	1,000	$3,463
-20%	$14.00	$10,401		-20%	800	$1,045
-10%	$15.75	$6,932		-10%	900	$2,254
0%	$17.50	$3,463		0%	1,000	$3,463
10%	$19.25	-$6		10%	1,100	$4,673
20%	$21.00	-$3,475		20%	1,200	$5,882
	Deviation	NPV at Different Deviations from Base
	from	Sales	Variable
	Base Case	Price	Cost/Unit	Units Sold
	-20%	-$5,893	$10,401	$1,045
	-10%	-$1,215	$6,932	$2,254
	0%	$3,463	$3,463	$3,463
	10%	$8,141	-$6	$4,673
	20%	$12,820	-$3,475	$5,882
	Range	$18,712	$13,876	$4,837
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.
			Sales	Unit	Variable
Scenario		Probability	Price	Sales	Costs	NPV
Best Case		25%	$28.80	1,200	$14.00	$25,435
Base Case		50%	$24.00	1,000	$17.50	$3,463
Worst Case		25%	$19.20	800	$21.00	($11,990)
					Expected NPV =	$5,093
					Standard Deviation =	$13,332
					Coefficient of Variation = Std Dev / Expected NPV =	2.62
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:				0.8	to	1.2
Low-risk WACC =		8%
WACC =		10%
High-risk WACC =		13%
Risk-adjusted WACC =		13%
	Risk adjusted NPV =	$2,387
	IRR =	21.09% Kenneth D. Jackson: IRR does not change.
	Payback =	2.90 Kenneth D. Jackson: Paypack does not change.
e. On the basis of information in the problem, would you recommend that the project be accepted?
At this point, the project looks risky but acceptable. There is a good chance that it will produce a positive NPV, but there is also a chance that the NPV could be quite low.
The problem gave no information about the size of the project relative to the total corporation. If the company were quite large, and this were but one of many projects, and if the projects were independent of one another, then it should be accepted. However, if the firm were relatively small, and this project under bad conditions could bankrupt the company, then the decision is not clear. If management is highly risk averse, they might turn it down. However, well-diversified investors would probably prefer to see it accepted. So, to maximize the stock price, it should be accepted.
We indicate in the problem that this project's returns will tend to be highly correlated with the firm's other projects' returns. Thus, its stand-alone risk (which is what we have been analyzing) also reflects its within-firm risk. If this were not true, then we would need to make further risk adjustments.

Sensitivity Analysis

Sales price -0.2 -0.1 0 0.1 0.2 -5892.876254354208 -1214.7695184755212 3463.3372174031774 8141.4439532818797 12819.550689160566 VC -0.2 -0.1 0 0.1 0.2 10401.207376545313 6932.2722969742463 3463.3372174031774 -5.5978621678877971 -3474.5329417389548 Units -0.2 -0.1 0 0.1 0.2 1044.9939047879197 2254.1655610955495 3463.3372174031774 4672.5088737108053 5881.6805300184315

Percentage Deviation from Base

NPV ($)

Scenario Summary

	Scenario Summary
			Current Values:	Base	Best	Worst
				Created by Michael C. Ehrhardt on 11/13/2001	Created by Michael C. Ehrhardt on 11/13/2001 Modified by Michael C. Ehrhardt on 11/13/2001	Created by Michael C. Ehrhardt on 11/13/2001
	Changing Cells:
		$D$29	1,000	1,000	1,200	800
		$D$30	$24.00	$24.00	$28.80	$19.20
		$D$31	$17.50	$17.50	$14.00	$21.00
	Result Cells:
		$D$79	$3,463	$3,463	$25,435	($11,990)
		$D$80	21.09%	21.09%	76.96%	ERROR:#NUM!
		$D$81	16.99%	16.99%	43.42%	-41.46%
	Notes: Current Values column represents values of changing cells at
	time Scenario Summary Report was created. Changing cells for each
	scenario are highlighted in gray.