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A 11problem

E
27.12.2007 09:25

I 10.02.2003

Chapter 11. Solution to end-of-chapter spreadsheet problem

Webmasters.com has developed a powerful new server that would be used for corporations Internet activities. It would cost $10 million to buy the equipment necessary to manufacture the server, and $3 million of net operating working capital would be required. The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. The companys fixed costs would also rise by $1 million per year. It would take one year to buy the required equipment and set up operations, and the server project would have a life of 4 years. Conditions are expected to remain stable during each year of the operating life, i.e., unit sales, the sales price, and costs would be unchanged. If the project is undertaken, it must be continued for the entire 4 years. Also, the projects returns are expected to be highly correlated with returns on the firms other assets. The equipment would be depreciated over a 5-year period, using MACRS rates as described in Appendix 12A. The estimated market value of the equipment at the end of the projects 4-year life is $500,000. Webmasters federal-plusstate tax rate is 40%. Its cost of capital is 10% for average risk projects, defined as projects with a coefficient of variation for 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. (Hint: You might want to modify the model on file 11model rather than create an entirely new model.) Key Output: Part 1. Key Input Data Equipment cost Net Operating WC First year sales (in units) Sales price per unit Variable cost per unit Fixed costs $10.000 $3.000 1.000 $24,00 $17,50 $1.000 NPV = IRR = MIRR = $2.863 18,8% 15,6% $500 40% 10%

Market value of equipment in 2005 Tax rate WACC

Part 2. Depreciation and Amortization Schedule Year Initial Cost Equipment Deprn Rate Equipment Deprn, Dollars Ending Bk Val: Cost - Accum'd Deprn Part 3. Net Salvage Values, in 2005 Estimated Market Value in 2005 Book Value in 2005 Expected Gain or Loss Taxes paid or tax credit Net cash flow from salvage

1 20,0% $2.000

Years 2 32,0% $3.200

3 19,0% $1.900

4 12,0% $1.200 $1.700

Accum'd Deprn

$8.300

10.000

Equipment $500 1.700 -1.200 -480 $980

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A B C D E Part 4. Projected Net Cash Flows (Time line of annual cash flows) 0 Years, 1-4 basis 2001 Years, actual year basis Investment Outlays at Time Zero: Equipment -10.000 Increase in Net Operating WC -3.000 Operating Cash Flows over the Project's Life: Units sold Sales price Sales revenue Variable costs Fixed operating costs Depreciation (equipment) Oper. income before taxes (EBIT) Taxes on operating income (40%) Net Operating Profit After Taxes (NOPAT) Add back depreciation Operating cash flow Terminal Year Cash Flows: Return of net operating working capital Net salvage value Total termination cash flows Net Cash Flow (Time line of cash flows) ($13.000)

F 1 2002

G 2 2003

H 3 2004

I 4 2005

1.000 $24,00 $24.000 17.500 1.000 2.000 3.500 1.400 2.100 2.000 $4.100

1.000 $24,00 $24.000 17.500 1.000 3.200 2.300 920 1.380 3.200 $4.580

1.000 $24,00 $24.000 17.500 1.000 1.900 3.600 1.440 2.160 1.900 $4.060

1.000 $24,00 $24.000 17.500 1.000 1.200 4.300 1.720 2.580 1.200 $3.780 $3.000 980 $3.980

$4.100

$4.580

$4.060

$7.760

Part 5. Key Output: Appraisal of the Proposed Project

Net Present Value (at 12%) IRR MIRR Payback. See calculation below) Data for Payback $2.863 18,85% 15,61% 3,03 Applies MIN function to Row 64 to find first year when payback is positive. 0 -13.000 1 -8.900 FALSE 2 -4.320 FALSE 3 -260 FALSE 4 7.500 3,03

Years Cumulative CF from Row 53 IF Function to find 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 base case values. Include a graph in your analysis. Sensitivity of NPV to Changes in Inputs. Here we use an Excel "Data Table" to find NPV different unit sales, holding other thing constant.

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A B C D E F G 93 % Deviation 1st YEAR UNIT SALES % Deviation WACC 94 from Units NPV from NPV 95 Base Case Sold $2.863 Base Case WACC 2.863 96 -20% 800 $390 -20% 8,0% $3.650 97 -10% 900 $1.627 -10% 9,0% $3.249 98 0% 1.000 $2.863 Base Case 0% 10,0% $2.863 99 10% 1.100 $4.099 10% 11,0% $2.491 100 20% 1.200 $5.335 20% 12,0% $2.133 101 % Deviation 102 % Deviation VARIABLE COSTS SALES PRICE from Variable NPV from Sales NPV 103 Costs $2.863 Base Case Price $2.863 104 Base Case -20% $14,00 $9.520 -20% $19,20 -$6.266 105 -10% $15,75 $6.191 -10% $21,60 -$1.702 106 0% $17,50 $2.863 Base Case 0% $24,00 $2.863 107 10% $19,25 -$465 10% $26,40 $7.428 108 20% $21,00 -$3.794 20% $28,80 $11.992 109 110 FIXED COSTS 111 % Deviation from Fixed NPV 112 Costs $2.863 113 Base Case -20% $800 $3.243 114 -10% $900 $3.053 115 0% $1.000 $2.863 Base Case 116 10% $1.100 $2.673 117 20% $1.200 $2.483 118 119 120 121 Sensitivity Analysis 122 123 124 $11.000 125 $9.000 126 127 $7.000 128 $5.000 129 130 $3.000 131 $1.000 132 ($1.000) 133 134 ($3.000) 135 ($5.000) 136 137 ($7.000) 138 -20% -10% 0% 10% 20% 139 140 141

NPV

Sales price Variable cost Units sold

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A B C D E F G H 142 Deviation NPV at Different Deviations from Base 143 from Sales Variable Fixed 144 Base Case Price Cost/Unit Units Sold Cost NPV 145 -20% ($6.266) $9.520 $390 $3.243 $3.650 146 -10% ($1.702) $6.191 $1.627 $3.053 $3.249 147 0% $2.863 $2.863 $2.863 $2.863 $2.863 148 10% $7.428 ($465) $4.099 $2.673 $2.491 149 20% $11.992 ($3.794) $5.335 $2.483 $2.133 150 151 Range 18.258 13.313 5.726 761 1.516 152 153 c. Now conduct a scenario analysis. Assume that there is a 25% probability that best case conditions, with each of 154 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. 155 156 157 Squared 158 Deviation 159 Sales Unit Variable Times Probability 160 Probability Price Sales Costs NPV Scenario 161 25% $28,80 1.200 $14,00 $24.279 98379523 162 Best Case 50% $24,00 1.000 $17,50 $2.863 1246290 163 Base Case 25% $19,20 800 $21,00 ($12.238) 69553178 164 Worst Case 165 169178990 166 Expected NPV = sum, prob times NPV $4.442 167 Standard Deviation = Sq Root of column H sum $13.007 168 Coefficient of Variation = Std Dev / Expected NPV 2,93 169 a. Probability Graph 170 Probability 171 172 50% 173 174 175 25% 176 177 178 -12.238 0 4.442 24.279 179 NPV ($) 2.863 180 Most Likely Mean of distribution 181 182 b. Continuous Approximation 183 184 Probability Density 185 186 187 188 -12.238 0 4.442 24.279 189 NPV ($) 190 2.863 191

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The scenario analysis suggests that the project could be highly profitable, but also that it is quite risky. There is a 25% probability that the project would result in a loss of $12.2 million. There is also a 25% probability that it could produce an NPV of $22.5 million. The standard deviation is high, at $9.2 million, and the coefficient of variation is a high 2.33.

d. If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and payback. With the high CV, we must re-evaluate the project using a higher WACC, 13%. NPV IRR payback $1.788 18,85% 3,03

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 quite low. Also notice, that parameters like IRR and payback are unaffected by a changing discount rate.

e. On the basis of information in the problem, would you recommend that the project be accepted?

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