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12 Chapter Model
12 Chapter Model
2/16/2006
3/9/2016 4:05
Page 1
$12,000
$8,000
$6,000
20,000
0.0%
$3.00
$2.10
$8,000
2007
1.3%
$156
$156
$11,844
Years
2008
2.6%
$312
$468
$11,532
2009
2.6%
$312
$780
$11,220
2010
2.6%
$312
$1,092
$10,908
20.0%
$1,600
$1,600
$6,400
32.0%
$2,560
$4,160
$3,840
19.0%
$1,520
$5,680
$2,320
12.0%
$960
$6,640
$1,360
$7,500
$2,000
40%
12%
0.0%
0.0%
0.0%
The indicated percentages are multiplied by the depreciable basis ($12,000 for the building and $8,000 for
the equipment) to determine the depreciation expense for the year.
Building Equipment
$7,500
$2,000
10,908
1,360
-3,408
640
-1,363
256
$8,863
$1,744
Total
$10,607
Book value equals depreciable basis (initial cost in this case) minus accumulated MACRS depreciation.
For the building, accumulated depreciation is $1,092, so book value is $12,000 - $1,092 = $10,908. For the
equipment, accumulated depreciation is $6,640, so book value is $8,000 - $6,640 = $1,360.
Building: $7,500 market value - $10,908 book value = -$3,408, a loss. Thus there's a shortfall in depreciation
taken versus "true" depreciation, and it is treated as an operating expense for 2010. Equipment: $2,000
market value - $1,360 book value = $640 profit. Here the depreciation charge exceeds the "true"
depreciation, and the difference is called "depreciation recapture". It is taxed as ordinary income in 2010.
Net cash flow from salvage equals salvage (market) value minus taxes. For the building, the loss results
in a tax credit, so net salvage value = $7,500 - (-$1,363) = $8,863.
Page 2
1
2007
Years
2
2008
3
2009
-$12,000
-8,000
-6,000
20,000
$3.00
20,000
$3.00
20,000
$3.00
20,000
$3.00
$60,000
42,000
8,000
156
1,600
$8,244
3,298
$4,946
1,756
$6,702
$60,000
42,000
8,000
312
2,560
$7,128
2,851
$4,277
2,872
$7,149
$60,000
42,000
8,000
312
1,520
$8,168
3,267
$4,901
1,832
$6,733
$60,000
42,000
8,000
312
960
$8,728
3,491
$5,237
1,272
$6,509
4
2010
$6,000
10,607
$16,607
-$26,000
$6,702
$7,149
$6,733
$23,116
Net working capital will be recovered at the end of the project's operating life, at year-end 2010, as
inventories are sold off and receivables are collected.
$5,166
19.33%
17.19%
3.23
3.23
Years
2
-26,000
-
-19,298
-
-12,149
-
-5,416
-
17,700
3.23
Payback: We first calculate the cumulative CFs. The payback period is the year before the cumulative
CF turns positive, which in this case is 3, plus a fraction equal to (unrecovered after Year 3) / (CF in
Year 4) = 0.23, so the payback is 3.23 years.
We also used an Excel Logical Function to automate payback calculation. This is useful if you plan
to do sensitivity analysis or want to analyze a lot of projects. See the Excel tutorial on the Web site for
an explanation of the payback function we developed.
Page 3
Based on the 12% WACC, the project's NPV is $5,166. Since the NPV is positive and both the IRR
and MIRR exceed the WACC, we tentatively conclude that the project should be accepted. Note,
though, that no risk analysis has been conducted. It is possible that BQC's managers, after appraising
the project's risk, might conclude that its projected return is insufficient to compensate for the risk
and thus reject it. Also, senior managers might conclude that the project is inconsistent with the firm's
long-run strategic plan. Finally, bringing in real options, which we discuss in Chapter 13, might
change the project's risk/return profile.
The model analyzes the sensitivity of the project's NPV to variations in WACC, unit sales, variable
costs, growth rates, sales price, and fixed costs. We developed the following Excel Data Tables to find
NPV at different levels for each variable, holding other things constant.
% Deviation
from
Base Case
-30%
-15%
0%
15%
30%
WACC
WACC
8.4%
10.2%
12.0%
13.8%
15.6%
NPV
from
5,166
Base Case
$8,294
-30%
$6,674
-15%
$5,166 Base Case
0%
$3,761
15%
$2,450
30%
VARIABLE COSTS
% Deviation
from
Variable
NPV
from
Base Case
Cost
$5,166
Base Case
-30%
$1.47
$28,129
-30%
-15%
$1.79
$16,647
-15%
0%
$2.10
$5,166 Base Case
0%
15%
$2.42
-$6,315
15%
30%
$2.73
-$17,796
30%
% Deviation
% Deviation
from
Base Case
-30%
-15%
0%
15%
30%
SALES PRICE
% Deviation
Sales
NPV
from
Price
$5,166
Base Case
$2.10
-$27,637
-30%
$2.55
-$11,236
-15%
$3.00
$5,166 Base Case
0%
$3.45
$21,568
15%
$3.90
$37,970
30%
Units
Sold
14,000
17,000
20,000
23,000
26,000
FIXED COSTS
Fixed
NPV
Costs
$5,166
$5,600
$9,540
$6,800
$7,353
$8,000
$5,166
$9,200
$2,979
$10,400
$792
Page 4
We summarize the data tables, arranged by sensitivity, and graph the results in the following chart:
$45,925
$27,116
$19,682
$8,748
WACC
$8,294
6,674
5,166
3,761
2,450
$5,844
NPV
$20,000
$10,000
Unit sales
WACC
$0
Fixed cost
-$10,000
Variable cost
-$20,000
-$30,000
-30%
-15%
0%
Deviation
15%
30%
We see from the graph and the tables that NPV is quite sensitive to changes in the sales price and
variable costs, somewhat sensitive to changes in first-year sales and the sales growth rate, and not
very sensitive to changes in WACC and fixed costs. Thus, the key issue is our confidence in the
forecasts of the sales price and variable costs.
Note too that NPV can change dramatically if the key input variables change, but we do not know how
much the variables are likely to change. For example, if we were buying components under a fixed
price contract, then variable costs might be locked in and not likely to rise by more than say 5%, and
we might have a firm contract to sell the projected number of units at the indicated price per unit. In
that case, the "bad conditions" would not materialize, and a positive NPV would be pretty well
guaranteed. We bring probabilities of different conditions into the analysis in Part 7.
Page 5
Units
Price
VC
26,000
$3.90
$1.47
Base
20,000
$3.00
$2.10
Bad
14,000
$2.10
$2.73
Prob:
25%
50%
25%
0
-26,000
-26,000
-26,000
4
50,224
23,116
7,024
NPV @
12%
$87,503
$5,166
-$43,711
Expected NPV
Standard deviation
Coefficient of Variation
$13,531
$47,139
3.48
a. Probability Graph
Probability
50%
25%
-$43,711
$87,503
NPV ($)
$5,166
Most Likely NPV
$13,531
Expected NPV
b. Continuous Approximation
Probability Density
-$43,711
$0
$87,503
NPV ($)
$5,166
Page 6
The scenario analysis suggests that the project would be highly profitable, but it is quite risky. There is
a 25% probability that the project would result in a loss of $43.7 million. There is also a 25%
probability that it could produce an NPV of $87.5 million. The standard deviation is high, at $47.1
million, and the coefficient of variation is a high 3.48.
Note that the expected NPV in the scenario analysis is much higher than the base case value. This
occurs because under good conditions we have high numbers multiplied by other high numbers,
giving a very high result.
This analysis suggest that the project is relatively risky, thus the base case NPV should be
recalculated using a higher WACC. At a WACC of 15%, the base case NPV is shown below. That
number is not very high in relation to the project's cost.
NPV @ 15% =
$2,877
Changing the WACC would also change the scenario analysis. Here are new figures:
Best Case
Base Case
Worst Case
Prob.
25%
50%
25%
Expected NPV:
Standard Deviation:
Coefficient of Variation:
NPV @ 15%
$80,270
$2,877
($43,065)
$10,740
$44,309
4.13
Based on the analysis to 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 dramatically higher or
lower.
If the bad conditions occur, this will hurt but not bankrupt the firm--this is just one project for a large
company.
We also noted that this project's returns would be highly correlated with the firm's other projects and
also with the general stock market. Thus, its stand-alone risk (which is what we have been analyzing)
also reflects its within-firm and market risk. If this were not true, then we would need to consider risk
further.
Finally, recall that we stated at the start that if the firm undertakes the project, it will be committed to
operate it for the full 4-year life. That is important, because if it were not so committed, then if the bad
conditions occurred during the first year of operations, the firm could simply close down operations.
This would cut its losses, and the worse case scenario would not be nearly as bad as we indicated.
Then, the expected NPV would be higher, and the standard deviation and coefficient of variation would
be lower. We extend the model to deal with abandonment and other real options in the next tab, "Real
Options".
Page 7
Base
12000
8000
6000
20000
0
3
2.1
8000
Page 8
Base
7500
2000
0.4
0.12
0
0
0
Page 9
Best Case
12000
8000
6000
26000
0
3.9
1.47
8000
Page 10
Best Case
7500
2000
0.4
0.12
0
0
0
Page 11
Worst Case
12000
8000
6000
14000
0
2.1
2.73
8000
Page 12
Worst Case
7500
2000
0.4
0.12
0
0
0
Page 13
A
1
2
3
4
5
Input Data
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
$12,000
$5,000
$2,000
$1,000
$2,500
$1,000
40%
11.5%
Depr'n
1
33%
$3,960
2
45%
$5,400
3
15%
$1,800
4
7%
$840
$3,000
3,960
500
$3,460
1,384
$4,384
$3,000
5,400
500
$4,900
1,960
$4,960
$3,000
1,800
500
$1,300
520
$3,520
$3,000
840
500
$340
136
$3,136
$3,000
0
500
-$500
-200
$2,800
Years
-$12,000
1,000
600
(1,000)
$2,000
-800
1,000
$2,200
-$11,400
$4,384
$4,960
0
($11,400)
-
1
($7,016)
-
$3,520
$3,136
$5,000
Years
2
3
($2,056)
$1,464
2.58
4
$4,600
-
$3,991
25.03%
18.40%
2.58
5
$9,600
-
A
1
2
3
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
The net present value method is used to analyze the advantages of refunding. The firm should refund
only if the present value of the savings exceeds the cost of the refunding. The after-tax cost of debt
should be used as the discount rate, since there is relative certainty to the cash flows to be received.
Using the example laid out in Web Appendix 12C, we will now evaluate such a scenario.
$60,000
$3,000
25
5
10%
12%
5.4%
New
New
New
New
bond issue
flotation cost
bond maturity
cost of debt
Tax rate
Short-term interest rate
$60,000
$2,650
20
9%
40%
6%
After-tax
-$6,000
-2,650
2,400
-600
300
-$3,600
-2,650
960
-360
180
-$5,470
$133
-120
$13
$53
-48
$5
$7,200
-5,400
$1,800
$4,320
-3,240
$1,080
Since the annual flotation cost tax effects and interest savings occur for the next 20 years, they
represent annuities. To evaluate this project, we must find the present values of these savings. Using
the function wizard and solving for present value, we find that the present values of these annuities are:
Calculating the annual flotation cost tax effects and the annual interest savings
Annual flotation Cost Tax Effects
Maturity of the new bond
After-tax cost of new debt
Annual flotation cost tax savings
20
5.4%
$5
$60
20
5.4%
$1,080
$13,014
Hence, the net present value of this bond refunding project will be the sum of the initial outlay and the
present values of the annual flotation cost tax effects and interest savings.
Initial Outlay
($5,470)
$7,604
+
+
PV of flot. costs +
$60
+
PV of interest savings
$13,014
A
55
56
57
58
Our refunding analysis tells us that should the firm proceed with the bond refunding, the project will
have a positive net present value. However, unlike traditional capital budgeting decisions, the positive
NPV does not tell the firm if it should refund the bond issue now. That decision is dependent upon
several external factors, including interest rate expectations.
SECTION 12.2
SOLUTIONS TO SELF-TEST QUESTIONS
1a If the WACC increased to 15% in Table 12-1, what would the new NPV be?
WACC
15%
CFs
0
-$26,000
NPV =
$2,877
1
$6,702
Years
2
$7,149
3
$6,733
4
$23,116