Chapter 13. Solution to Ch 13-11 Build a Model
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 it would require net working capital equal to 10% of sales. The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. After the first year, the sales price and variable costs would increase at the inflation rate of 3%. The company’s fixed costs would be $1 million per year, and would increase with inflation. 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. 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 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 project’s NPV, IRR, and payback.
Key Output: NPV =
Part 1. Input Data (in thousands of dollars) IRR =
MIRR =
Equipment cost $10.000
Net Operating WC/sales 10% Market value of equipment in 2006 $500
First year sales (in units) 1.000 Tax rate 40%
Sales price per unit $24.00 WACC 10%
Variable cost per unit $17.50 Inflation 3.0%
Fixed costs $1.000
Part 2. Depreciation and Amortization Schedule Years Accum’d
Year Initial Cost 1 2 3 4 Depr’n
Equipment Depr’n Rate 20.0% 32.0% 19.0% 12.0%
Equipment Depr’n, Dollars
Ending Bk Val: Cost – Accum Dep’rn
Part 3. Net Salvage Values, in Year 4 Equipment
Estimated Market Value in Year 4
Book Value in Year 4
Expected Gain or Loss
Taxes paid or tax credit
Net cash flow from salvage
Part 4. Projected Net Cash Flows (Time line of annual cash flows)
Years 0 1 2 3 4
Investment Outlays at Time Zero:
Equipment
Operating Cash Flows over the Project’s Life:
Units sold
Sales price
Variable costs
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:
Required level of net operating working capital $0 $0 $0 $0 $0
Required investment in NOWC $0 $0 $0 $0 $0
Terminal Year Cash Flows:
Net salvage value 0
Net Cash Flow (Time line of cash flows) $0 $0 $0 $0 $0
Part 5. Key Output: Appraisal of the Proposed Project
Net Present Value (at 10%) $0
IRR #NUM!
MIRR #DIV/0!
Payback (See calculation below) 0.00
Data for Payback Years 0 1 2 3 4
Cumulative CF from Row 53 0 0 0 0 0
IF Function to find payback FALSE FALSE FALSE FALSE
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.
Part 6. Evaluating Risk: Sensitivity Analysis
I. Sensitivity of NPV to Changes in Inputs. Here we use an Excel “Data Table” to find NPV different unit sales, holding other thing constant.
% Deviation 1st YEAR UNIT SALES % Deviation WACC
from Units NPV from NPV
Base Case Sold $0 Base Case WACC 0
-20% 800 $0 -20% 8.0% $0
-10% 900 $0 -10% 9.0% $0
0%
1.000
$0 0% 10.0% $0
10% 1.100 $0 10% 11.0% $0
20% 1.200 $0 20% 12.0% $0
% Deviation VARIABLE COSTS % Deviation SALES PRICE
from Variable NPV from Sales NPV
Base Case Costs $0 Base Case Price $0
-20% $14.00 $0 -20% $19.20 $0
-10% $15.75 $0 -10% $21.60 $0
0% $17.50 $0 0% $24.00 $0
10% $19.25 $0 10% $26.40 $0
20% $21.00 $0 20% $28.80 $0
% Deviation FIXED COSTS 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 number of units sold in cell B104 should be the number 1000; you should NOT have the formula =D29 in that cell. This is because you’ll use D29 as the column input cell in the data table and if Excel tries to iteratively replace cell D29 with the formula =D29 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 Fixed NPV
Base Case Costs $0
-20% $800 $0
-10% $900 $0
0% $1.000 $0
10% $1.100 $0
20% $1.200 $0
Deviation NPV at Different Deviations from Base
from Sales Variable Fixed
Base Case Price Cost/Unit Units Sold Cost WACC
-20% $0 $0 $0 $0 $0
-10% $0 $0 $0 $0 $0
0% $0 $0 $0 $0 $0
10% $0 $0 $0 $0 $0
20% $0 $0 $0 $0 $0
Range 0 0 0 0 0
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.
Part 7. Evaluating Risk: Scenario Analysis Squared
Deviation
Sales Unit Variable Times
Scenario Probability Price Sales Costs NPV Probability
Best Case 25% $28.80 1.200 $14.00
Base Case 50% $24.00 1.000 $17.50
Worst Case 25% $19.20 800 $21.00
Expected NPV = sum, prob times NPV $0
Standard Deviation = Sq Root of column H sum $0
Coefficient of Variation = Std Dev / Expected NPV #DIV/0!
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%. That results in:
Risk adjusted NPV =
IRR =
Payback =
e. Based on the information in the problem, would you recommend that the project be accepted?
