Chapter 5

Example
pg. 111
Sell price of microprocessor

$20
Facility A

Fixed Costs ($)

Variable Costs ($)

5.1

8 mil
4 per unit

Measuring Project Riskiness

Project just breaks even

Total Revenue = Total Cost
PxQ = F+VxQ
P sales price per unit
Q unit volume
F fixed costs
V unit variable cost
5.2 rearrange the terms to get the breakeven quantity
F
Q=
(P - V)
Facility A
8

8
16

4
10

20 - 4
Facility B
20 - 10

To see which facility is best, solve where A's profits = B's profits.
Profit for A = Revenue - Cost = Profit B = Revenue - Cost
P x Q - F A - VA x Q = P x Q - F B - VB x Q

20Q - 8 mil - 4Q = 20Q - 4 mil - 10Q

16Q - 8 mil =
10Q - 4 mil
6Q = 4 mil
666,667 = Q

Sensitivity analysis: change one variable, and see what happens to NPV; see how s

5.2
Box 5.1 page 120
Year
Initial Investment
Sales
Tons sold
Price
Revenue
Costs
Variable costs (90,000 x $140)
Fixed Costs
Depreciation
Total Costs
Net Income
Taxes (@50%)
After tax income
Depreciation
NCF

Sensitivity Analysis
0
(100,000,000)

90,000
660
$59,400,000

PVIFA15,10
result
Less: initial investment
NPV =

12,600,000
12,000,000
10,000,000
34,600,000
24,800,000
12,400,000
12,400,000
10,000,000
22,400,000
5.0188
112,421,120
(100,000,000)
$12,421,120

Now, suppose Fixed costs increase to $15 million, all else remains constant
What happens to NPV?

Year
Initial Investment
Sales
Tons sold
Price
Revenue
Costs
Variable costs (90,000 x $140)
Fixed Costs
Depreciation
Total Costs
Net Income
Taxes (@50%)
After tax income
Depreciation
NCF

0
(100,000,000)

90,000
660
$59,400,000

PVIFA15,10
result
Less: initial investment
NPV =

12,600,000
15,000,000
10,000,000
37,600,000
21,800,000
10,900,000
10,900,000
10,000,000
20,900,000
5.0188
104,892,920
(100,000,000)
$4,892,920

Page 122
What happens to NPV?
If only 80,000 tons sold, all else remains constant
Year
0
1
Initial Investment
(100,000,000)
Sales
Tons sold
80,000
Price
660
Revenue
$52,800,000
Costs
Variable costs (90,000 x $140)
11,200,000
Fixed Costs
12,000,000
Depreciation
10,000,000

Total Costs
Net Income
Taxes (@50%)
After tax income
Depreciation
NCF
PVIFA15,10
result
Less: initial investment
NPV =

33,200,000
19,600,000
9,800,000
9,800,000
10,000,000
19,800,000
5.0188
99,372,240
(100,000,000)
$(627,760)

What happens to NPV?

If only 100,000 tons sold, all else remains constant
Year
0
1
Initial Investment
(100,000,000)
Sales
Tons sold
100,000
Price
660
Revenue
$66,000,000
Costs
Variable costs (90,000 x $140)
14,000,000
Fixed Costs
12,000,000
Depreciation
10,000,000
Total Costs
36,000,000
Net Income
30,000,000
Taxes (@50%)
15,000,000
After tax income
15,000,000
Depreciation
10,000,000
NCF
25,000,000
PVIFA15,10
5.0188
result
125,470,000
Less: initial investment
(100,000,000)
NPV =
$25,470,000

Break-even Analysis
page 123
Exhibit 5.3
discount rate
Starship Project
Initial Investment
$250,000,000 10 yr life
PV of investment tax benefits
120,000,000 given
Initial Investment-net
130,000,000
Price/plane
2,700,000
Variable Costs per plane
1,500,000
Fixed Costs
15,000,000

10%

Exhibit 5.4 Breakeven Analysis for Starship Project

Annual Plane Sales (units)
Revenue
VC
Fixed cost
Net Income
Taxes @ 50%
After tax income
PV @ 10%
Initial Investment
Project NPV @ 10%

0
15,000,000
(15,000,000)
(7,500,000)
(7,500,000)
(46,084,500)
130,000,000
(176,084,500)

50
135,000,000
75,000,000
15,000,000
45,000,000
22,500,000
22,500,000
138,253,500
130,000,000
8,253,500

The point at which the project NPV is just -0- is slightly fewer than 50 planes annually
To calculate the actual breakeven point:
I0 - D
Q= PVIFAr,n (P-V)(1-t)
I0 Initial Investment
D PV of Depr w/o & ITC
Q annual sales
P unit sales price

250.00
120.00
2.70

V unit variable cost

F annual fixed cost
t tax rate
n project life
r discount rate
130
3.68676
35.2613134568

1.50
15.00
50%
10.00
10%
+

Facility B
4 mil
10 per unit

skiness

0.50

500,000 breakeven point

0.40

400,000 breakeven point

happens to NPV; see how sensitive that variable can be on the project

mains constant

Tax rate
50%
Life 10 yr
2
3

Discount rate
4

15%
5

the only item that changed

else remains constant

NPV negative

ll else remains constant

75
202,500,000
112,500,000
15,000,000
75,000,000
37,500,000
37,500,000
230,422,500
130,000,000
100,422,500
than 50 planes annually

F
P-V

PVIFA 10, 10

6.1446

15.00
1.20
12.5

48 breakeven quantity

PVIFA Calculator
Interest rate per period:

Number of period:
PVIFA Result

5.0188

PVIFA15,10
7

5.0188
8

10

Chapter 5
Risk Analysis in Capital Budgeting
Sample Problem 1
page 137
1). Calculate the NPV of an investment with the following characteristics:
Units sold per year
55,000
Price per unit
$800
Variable cost per unit
$720
Fixed Costs
0
Initial cost
$20,000,000
Life of the project
10 years
Discount rate
10%
Depreciation
SL
Tax Rate
34%
- PV (cost)
+ PV(depreciation tax shield)
+ PV(operating CF's)
= NPV

PV (cost)

$20,000,000 Initial cost

PV(depreciation tax shield)

PV(depreciation tax shield)

PV(operating CF's)
price

2,000,000 depreciation/year
34% Tax Rate
$680,000
6.1446 PVIFA
$4,178,328

(Price-Cost)(units)(1-tax rate)PVIFA10,10
$800

cost

(720)

price-cost

$80

# of units
(Price-Cost)(units)
1 minus the tax rate
PVIFA
(1-tax rate)PVIFA10,10

55,000
4,400,000
0.66
6.1446
4.055436
$17,843,918

PV(operating CF's)

a). Suppose an add'l investment of $5 mil would reduce the variable cost per unit to
Calc the NPV for this alternative
- PV (cost)
+ PV(depreciation tax shield)
+ PV(operating CF's)
= NPV

PV (cost)
PV(depreciation tax shield)

PV(depreciation tax shield)

PV(operating CF's)
price
cost
price-cost

$25,000,000 PV(operating CF's)

2,500,000 depreciation/year
34% Calc the NPV for this alternative
$850,000
6.1446 PVIFA
$5,222,910

(Price-Cost)(units)(1-tax rate)PVIFA10,10
$800
$(700) reduced variable cost
$100

# of units
(Price-Cost)(units)

(1-tax rate)PVIFA10,10
PV(operating CF's)

$55,000
$5,500,000
0.66 1-tax rate
6.1446 PVIFA
4.055436
$22,304,898

b). What is the breakeven (NPV) number of units for the 2 alternatives?
Breakeven occurs when: PV(operating CF's) = PV (cost) - PV (depreciation tax shiel
case 1
(800-720)(X)(.66)(6.1446)
PV (cost)
$20,000,000
PV(depreciation tax shield)
$4,178,328
$15,821,672
80
48,767 units
4.055436
324.43488
Part a
# of units

(800-700)(X)(.66)(6.1446)
0
$25,000,000
$5,222,910
$19,777,090
100
48,767 units
4.055436
405.5436

haracteristics:

see below for individual calc's

$(20,000,000)
$4,178,328
$17,843,918
$2,022,246 answer

epreciation/year

10 yrs, 10% discount rate

http://www.miniwebtool.com/pvifa-calculator/?r=10&n=7

PVIFA Calculator
Interest rate per
period:
Number of period:

PVIFA Result

6.1446

e the variable cost per unit to $700

see below for individual calc's
$(25,000,000)
$5,222,910
$22,304,898
$2,527,808

V(operating CF's)

added 5 mil to initial investment

epreciation/year
alc the NPV for this alternative
10 yrs, 10% discount rate
http://www.miniwebtool.com/pvifa-calculator/?r=10&n=7

duced variable cost

10 yrs, 10% discount rate

e 2 alternatives?
t) - PV (depreciation tax shield)

The break-even quatities are the same for case 1 & part a

Chapter 5
Risk Analysis in Capital Budgeting
Sample Problem 2
page 138
Multifoods, a retail grocery chain
4 parameters, can take on 1 of 2 possible values
5 year life
Tax rate
35%
Cost of capital
12%
Initail Investment
$150,000
Parameter
Revenue/year
Fixed cost/year
Vaiable cost/year
Depreciation/year

Pos Value 1 Pos Value 2

100,000
20,000
10,000
10,000

4
2
8

125,000
15,000
5,000
10,000

Selection is independent of each parameter value, & has 50% probability

a). Construct a probability distribution
Scenario
Revenue
-fixed cost
-variable cost
-depreciation
=taxable income
-tax
=after tax income
+depreciation
=CF

1
100,000
(20,000)
(10,000)
(10,000)
60,000
(21,000)
39,000
10,000
49,000

Since each parameter has a probabilit

2

100,000
(15,000)
(10,000)
(10,000)
65,000
(22,750)
42,250
10,000
52,250

3
100,000
(20,000)
(5,000)
(10,000)
65,000
(22,750)
42,250
10,000
52,250

4
100,000
(15,000)
(5,000)
(10,000)
70,000
(24,500)
45,500
10,000
55,500

xPVIFA12,5 factor
xPVIFA12,5 result
-investment
=NPV
std dev

3.6048
176,635
(150,000)
26,635
30.44

3.6048
3.6048
3.6048
188,351 188,351 200,066
(150,000) (150,000) (150,000)
38,351

38,351

50,066

The expected NPV given these 8 scenarios, with equal probability of being realized, equals
take average
67.64 8 scenarios, equal probability

parameters
possible values
scenarios

probability

parameter has a probability of .5, then 8 scenarios

5
125,000
(20,000)
(10,000)
(10,000)
85,000
(29,750)
55,250
10,000
65,250

6
125,000
(15,000)
(10,000)
(10,000)
90,000
(31,500)
58,500
10,000
68,500

7
125,000
(20,000)
(5,000)
(10,000)
90,000
(31,500)
58,500
10,000
68,500

8
125,000
(15,000)
(5,000)
(10,000)
95,000
(33,250)
61,750
10,000
71,750

3.6048
3.6048
3.6048
3.6048
235,213 246,929 246,929 258,644
(150,000) (150,000) (150,000) (150,000)
85,213

96,929

ility of being realized, equals:

96,929

108,644

PVIFA
Calculator
Interest rate per
period:
Number of period:
PVIFA Result

3.6048