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12 Chapter model

2/15/2006

11/7/2014 8:27

Chapter 12. Cash Flow Estimation and Risk Analysis


This worksheet contains a model to analyze BQC's new computer control project. Models for analyzing
real options, replacement decisions, projects with unequal lives, and bond refunding are also provided
on separate worksheets. Access those models by pressing the appropriate TAB key at the bottom of
the screen.
Later in the model, we extend the analysis done here to deal with real options and other topics (see
tabs below).

PROJECT ANALYSIS (Section 12.2)


The main model, on this tab, evaluates the computer project. Part 1 lists the key inputs used in the
calculations. Part 2 develops the depreciation data. Part 3 estimates the cash flows from disposing of
the building and the equipment at the end of the project's life. Part 4 calculates the cash flows during
each year of the project's operating life. Part 5 then uses the estimated cash flows to estimate the key
outputs and shows them as a time line which is used to calculate the NPV, IRR, MIRR, and Payback.
Finally, in Parts 6 and 7, we consider the riskiness of the project by showing how changes in the
inputs would result in changes in the key outputs.
All dollars are shown in thousands. Data are taken from the example in Chapter 12.
The model also does a scenario analysis where three variables--unit sales, the sale price, and the
VC%--are changed. Other variables are held constant at their base case levels. The analysis can be
done manually by inserting data for the various scenarios into the input data cells. However, we also
set up Scenarios using the Scenario Manager tool, which is described in the Tutorial. This tool can be
used to move to the different scenarios, but it is not necessary.

Page 1

Table 12-1. Analysis of a New (Expansion) Project (Thousands of Dollars)


Part 1. Input Data
Building cost (= Depr'n basis)
Equipment cost (= Depr'n basis)
Net Operating WC
First year sales (in units)
Growth rate in units sold
Sales price per unit
Variable cost per unit
Fixed costs

$12,000
$8,000
$6,000
20,000
0.0%
$3.00
$2.10
$8,000

Market value of building in 2010


Market value of equip. in 2010
Tax rate
WACC
Inflation: growth in sales price
Inflation: growth in VC per unit
Inflation: growth in fixed costs

Part 2. Depreciation Schedule a


Building Depr'n Rate
Building Depr'n Expense
Cumulative Depr'n
Ending Book Value: Cost - Cum. Depr'n

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

Equipment Depr'n Rate


Equipment Depr'n Expense
Cumulative Depr'n
Ending Book Value: Cost - Cum. Depr'n

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.

Part 3. Salvage Value Calculations


Estimated Market Value in 2010
Book Value in 2010b
Expected Gain or Lossc
Tax liability or credit
Net cash flow from salvaged

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

Part 4. Projected Cash Flows


0
2006
Investment Outlays at Time Zero
Building
Equipment
Increase in Net Working Capital

1
2007

Years
2
2008

3
2009

-$12,000
-8,000
-6,000

Operating Cash Flows over the Project's Life


Units sold
Sales price
Sales revenue
Variable costs
Fixed operating costs
Depreciation (building)
Depreciation (equipment)
EBIT
Taxes on operating income (40%)
NOPAT
Add back depreciation
Operating cash flow (OCF)

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

Terminal Year Cash Flows


Return of net operating working capitale
Net salvage value
Total termination cash flows
Projected Cash Flows (CF time line)
with recovery of NWC and net salvage value
Projected Cash Flows (CF time line)
with terminal or horizon value
e

4
2010

$6,000
10,607
$16,607
-$26,000

$6,702

$7,149

$6,733

$23,116

-$26,000

$6,702

$7,149

$6,733

$47,562

Net working capital (NWC) 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.

Part 5. Appraisal of the Proposed Project


with recovery of NWC and net salvage value
$5,166
19.33%
17.19%
Manual Payback = 3 + 5,416/23,116=
3.23
Cumulative cash flow for payback:
Years
0
1
2

with terminal or horizon value


$20,702
34.90%
29.66%
3.11

NPV (at 12%)


IRR
MIRR

-26,000

-19,298

-12,149

-5,416

17,700

-26,000

-19,298

-12,149

-5,416

42,146

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 the next tab, might
change the project's risk/return profile.

MEASURING STAND-ALONE RISK (Section 12.5)


Part 6. Evaluating Risk: Sensitivity Analysis
Risk in capital budgeting essentially means the probability that the actual outcome will be much worse
than the expected outcome. For example, if there were a high probability that the $5,166 expected NPV
as calculated above will turn out to be quite negative, then the project would be classified as relatively
risky. The reason for a worse-than-expected outcome is, typically, that sales are lower than expected,
costs are higher than expected, or the project turns out to have a higher than expected initial cost. In
other words, if the assumed inputs turn out to be worse than expected, then the output will likewise be
worse than expected. We use Excel to examine the project's sensitivity to changes in the input
variables.
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%

% Deviation 1st YEAR UNIT SALES

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%

NPV Extra Question: At what


$5,166 1st Year Sales would
-$4,675 the project break even
$246 in the sense that NPV
$5,166 = $0?
$10,087
$15,007 Answer: You could plot
NPV against Sales and
see about where NPV
GROWTH RATE, UNITS = 0. Alternatively, you
Growth
NPV could use Tools > Goal
Rate %
$5,166 Seek as described in
-30%
-$5,847 the columns to the right.
-15%
-$907 The answer is 16,850
0%
$5,166 units.
15%
$12,512
30%
$21,269
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:

Figure 12-1. Evaluating Risk: Sensitivity Analysis (Dollars in Thousands)


Deviation
from
Base
-30%
-15%
0%
15%
30%
Range

NPV at Different Deviations from Base


Sales
Variable
Sales
Year 1
Fixed
Price
Cost/Unit Growth Units Sold
Cost
-$27,637
$28,129
-$5,847
-$4,675
$9,540
-11,236
16,647
-907
246
7,353
5,166
5,166
5,166
5,166
5,166
21,568
-6,315
12,512
10,087
2,979
37,970
-17,796
21,269
15,007
792
$65,607

$45,925

$27,116

$19,682

$8,748

WACC
$8,294
6,674
5,166
3,761
2,450
$5,844

Sensitivity Analysis Graph


40,000
Sales price
30,000
Sales growth

20,000

NPV

10,000

Unit sales
WACC

Fixed cost

-10,000
Variable cost

-20,000
-30,000
-30%

-15%

0%

15%

30%

Deviation

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

Part 7. Evaluating Risk: Scenario Analysis


Scenario analysis extends risk analysis in two ways: (1) It allows us to change more than one variable
at a time, hence to see the combined effects of changes in several variables, and (2) It allows us to
bring in the probabilities of changes in the key variables. In this section we do a scenario analysis for
the computer project.
We saw from the sensitivity analysis that the key variables are sales price, variable costs, unit sales,
and the unit growth rate. Therefore, in our sensitivity analysis we hold the other variables at their base
case levels and then examine the situation when the key variables change. We assume that the
company regards the worst case as one where each of the three variables is 30% worse than the base
level, and in the best case each variable is 30% better than base. We also assume that there is a 25%
chance of the best and worst cases, and a 50% chance of base case levels.

Figure 12-2. Scenario Analysis (Dollars in Thousands)


Scenario
Units
Price
VC

Good

Base

26,000
$3.90
$1.47

20,000
$3.00
$2.10

Bad

14,000
$2.10
$2.73

Scenario Cash Flows:


Best Case
Base
Worst Case

Prob:
25%
50%
25%

0
-26,000
-26,000
-26,000

Change the inputs to these values get the


NPVs for the different scenarios. When
finished, return to base case variable
levels. We also used Scenario Manager as
described in the Tutorial, but this step is
not necessary.
Predicted Cash Flow for Each Year
1
2
3
33,810
34,257
33,841
6,702
7,149
6,733
-9,390
-8,943
-9,359

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

REAL OPTIONS
In this model we examine four types of real options: abandonment, timing, growth, and
flexibility.

ABANDONMENT (Section 12.8)


We use BQC's computer control project as discussed in Section 12.2 to illustrate
abandonment. Recall that due to labor contracts and other constraints, that originally the
project could not be terminated before the end of its 4-year life.
We show below decision trees for three scenarios under the "Can't Abandon" and "Can
Abandon" cases. Cash flows are taken from the Chapter 12 model (previous tab), where they
were calculated. In Column B, we show the probabilities for each scenario. Next, in Columns C
through G, we show the annual cash flows under each scenario. Column H shows the NPV
under each scenario at a 12% risk-adjusted cost of capital. The probability times the NPV for
each branch of the tree is calculated in cell H21 (cell H32 if abandoned); it is the expected NPV.
Then, cell H22 (cell H33 if abandoned) gives the standard deviation, and the coefficient of
variation is shown in cell H23 (cell H34 if abandoned).
As noted, the project is risky, but it has a high expected NPV. It would probably be accepted,
but if things turn out badly, this would hurt the company rather badly.

Table 12-2. Decision Trees Without and With the Abandonment Option (Dollars in Thousands)
Situation 1. Cannot Abandon.

Best Case
Base
Worst Case

Prob:
25%
50%
25%

12%
Predicted Cash Flow for Each Year
0
1
2
3
4
-26,000
33,810
34,257
33,841
50,224
-26,000
6,702
7,149
6,733
23,116
-26,000
-9,390
-8,943
-9,359
7,024
Expected NPV
Standard Deviation (SD)
Coefficient of Variation (CV) = Std Dev/Expected NPV

Situation 2. Can Abandon.

Best Case
Base
Worst #1
Worst #2

Prob.
25%
50%
0%
25%

WACC =

0
-26,000
-26,000
-$26,000
-$26,000

NPV @
12%
$87,503
$5,166
-$43,711
$13,531
$47,139
3.48

WACC =

12%
End of Period Cash Flows:
1
2
3
33,810
34,257
33,841
6,702
7,149
6,733
-$9,390
-$9,390

-$8,943
$18,244

-$9,359
$0

4
50,224
23,116
$7,024
$0

Expected NPV
Standard Deviation (SD)
Coefficient of Variation (CV) = Std Dev/Expected NPV
Value of the Real Option to Abandon
Expected NPV with Abandonment

NPV @
12%
$87,503
$5,166
-$43,711 Disregard
-$19,840 Choose
$19,499
$40,567
2.08

$19,499

Expected NPV without Abandonment


Difference = Value of the Option

$13,531
$5,968

The possiblity of abandonment raises the expected NPV because some negative CFs will not
occur. The standard deviation also declines. Both of these changes cause the CV to decline.
The project's CV ends up close to 2.0, which is the average for BQC's projects, which in turn
suggests that it is appropriate to evaluate the project using the 12% WACC.
Finally, note that the difference between the expected NPV with and without abandonment
represents the value of the abandonment option.
It often turns out that without abandonment, the bad case outcome is so bad that it causes the
expected NPV to be negative, hence causes the project to look unacceptable. However, when
abandonment possibilities are factored in, the worse case outcome is not nearly as bad, and
the expected NPV becomes positive. Clearly, abandonment option possibilities must be
considered to obtain valid assessments for different projects.

Investment Timing Options (The analysis in the remainder of this tab deals with timing,
growth, and flexibility options as discussed in Web Appendix 12G)
An "investment timing option" involves the decision of when to commit to a project. If the
project can be delayed, then the expected NPV might be increased. Perhaps new technology
will become available to cut costs, or perhaps the firm can get a better idea of the size of the
market before committing to the project. In any event, timing options can be valuable.

Problem: Assume that Williams Inc. is considering a project that requires an initial investment
of $5 million in 2007. The project is expected to generate a constant stream of cash flows for
the next 4 years. However, the size of the cash flows would depend on future market
conditions. If the product were well received, then sales would be strong in the coming year
and would remain strong for the duration of the project's life. However, if the project performs
poorly in the coming year, cash flows would remain weak into the future. Under good
conditions, the annual net cash flow would be $2.5 million at the end of each of the next 4
years. Under bad conditions, cash flows would be $1.2 million per year. The probabilities of
strong and weak demand are both 50%, and the firm's cost of capital is 10%. The decision tree
is shown below. (All dollar figures are in millions.)
Proceed Immediately, i.e., Invest Now

Good Conditions
Bad Conditions

Prob.
50%
50%

2007
-$5.0
-$5.0

2008
$2.5
$1.2

End of Period:
2009
2010
$2.5
$2.5
$1.2
$1.2

2011
$2.5
$1.2

Expected NPV = sum, prob. times NPV


Standard Deviation
Coefficient of Variation = Std Dev / Expected NPV

With an expected NPV of $.864 million, the project appears to be profitable, but it does have a
high SD and CV, hence it is risky. That risk might warrant the use of a higher WACC, which
might make the NPV turn negative. However, note that the project's risk arises because we do
not know how demand will turn out next year. If we could wait until we had more information
about demand, the project's risk could be reduced. The expected NPV would be either high, in
which case we would accept the project, or low, in which case we would reject it. How should
the project be analyzed under this condition?
Problem: Suppose Williams can wait until next year to make the decision. If it waits, it will
have more information about market conditions. Whereas today it can only guess what
demand will be, if it waits a year it will know precisely what conditions actually are. All other
aspects of the project would be identical to conditions in the"Go Now" scenario shown above
with the sole exception that the decision will be delayed until 2008. What is the NPV if the
project is delayed for a year?
Delay Decision: Invest Only If Conditions Are Good

Good Conditions
Bad but irrelevant

50%
50%

Delay
Delay

2008
-$5.0
$0.0

2009
$2.5
$0.0

End of Period:
2010
2011
2012
$2.5
$2.5
$2.5
$0.0
$0.0
$0.0
Expected NPV
Standard Deviation
Coefficient of Variation

Discount the expected NPV back 1 year to make it comparable to "go now" NPV
Value of the Timing Option:

NPV Considering the Timing Option


NPV Without Considering the Timing Option
Value of the Timing Option

Growth Options
Some projects provide the firm with opportunities to pursue other profitable projects in the
future. Although a project appears to have a negative conventional NPV, it could be attractive
if it opens the door to new products or markets.
To illustrate, assume that Crum Corporation is considering a Chinese distribution center that
requires an initial investment of $3 million. If conditions are strong, it will provide 3 annual
cash flows of $1.5 million each. However, if conditions are weak, each annual cash flow will
only be $0.75 million. There is a 50% probability for each condition. Crum's WACC is 12%.
Management believes that if conditions are strong, this investment would lead to subsequent
investment opportunities in Year 2 that would cost $10 million, and the investment could be
sold for $20 million at the end of Year 3. What's the distribution center's NPV if we disregard
the potential new investment? What would the NPV be giving consideration to the option?
Analysis of a Growth Option
Project Disregarding the Growth Option:
End of Period

NPV@

Distr Ctr

Good
Bad

50%
50%

0
-$3.0
-$3.0

1
$1.500
$0.750

2
3
$1.500
$1.500
$0.750
$0.750
Expected NPV:

12%
$0.603
-$1.199
-$0.298

Project Considering the Growth Option:

NPV for good considering growth:

End of Period
0
1
2
-$3.000
$1.500
$1.500
-$10.000
-$3.000
$1.500
-$8.500

Bad

-$3.000

Good
Distr Ctr
New Inv.

Distr Ctr

50%

50%

$0.750

3
$1.500
$20.000
$21.500

$0.750
$0.750
Total Expected NPV:

NPV considering growth:


NPV not considering growth:
Value of the growth option:

NPV@
12%

$6.866
-$1.199
$2.834
$2.834

-$0.298
$3.132

Flexibility Options
Flexibility options, where plants are designed to use alternative inputs and/or to produce
alternative outputs depending on market conditions, are also important. For example,
suppose BQC is considering a new plant with a cost of $5 million. There is a 50% probability of
strong demand, in which case the project will provide annual cash flows of $2.5 million for 3
years, and a 50% probability of weak demand and cash flows of only $1.5 million. However, if
demand is weak, the company can convert the plant and produce an alternative product, and
in this case the cash flows in Years 2 and 3 would be $2.2 million. The situation is set forth in
the decision tree below. In a conventional NPV analysis, only the upper tree would be
considered, the NPV would be -$0.278, so the project would be rejected. However, if the
flexibility option were considered, the lower tree would be relevant, the expected NPV would
be $0.239, and the project would be accepted.
Project Disregarding the Flexibility Option:
Strong demand
Weak demand

50%
50%

0
-$5.0
-$5.0

End of Period
1
2
3
$2.5
$2.5
$2.5
$1.5
$1.5
$1.5
Expected NPV:

50%
0%
50%

0
-$5.0
-$5.0
-$5.0

End of Period
1
2
3
$2.5
$2.5
$2.5
$1.5
$1.5
$1.5
$1.5
$2.2
$2.2
Expected NPV:

Project Considering the Flexibility Option:


Strong demand
Weak demand

Don't switch products


Switch products

lars in Thousands)

NPV @
10%
$2.92
-$1.20
$0.864
$2.060
2.38

NPV @
10%
$2.92
$0.00
$1.462
$1.462
1.00
$1.329
$1.329
$0.864
$0.465

NPV@
13%
$0.903
-$1.458
-$0.278
NPV@
13%
$0.903
-$1.458
-$0.425
$0.239

A
B
C
D
E
F
1 REPLACEMENT PROJECT ANALYSIS (WEB APPENDIX 12B)
2

This model analyzes decisions related to replacing assets that are currently being used with
more efficient assets. While the mechanics of the analysis are somewhat different from that
3 used for a new project, the concepts are identical.
4
5
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

Input Data
Cost of the new machine
Reduction in operating costs
New machine's salvage value at end of Year 5
Old machine's current market value
Old machine's current book value
Increase in net operating working capital
Tax rate
WACC

$12,000
$5,000
$2,000
$1,000
$2,500
$1,000
40%
11.5%

MACRS 3-year Depreciation Schedule


Year
Depr. Rate

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

Projected Cash Flows


Investment Outlays at Time Zero
Cost of new equipment
Market value of old equipment
Tax savings on old equipment
Increase in net working capital

Years

-$12,000
1,000
600
(1,000)

Operating Cash Flows over the Project's Life


After-tax decrease in costs
Depreciation on new machine
Depreciation on old machine
Change in depreciation
Tax savings from depreciation
Operating cash flows
Terminal Year Cash Flows
Estimated salvage value of new machine
Tax on salvage value (40%)
Return of net operating working capital
Total termination cash flows
Projected Cash Flows (CF timeline)

$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

Appraisal of the Proposed Project


NPV (at 11.5%)
IRR
MIRR
Payback (Excel function)
Cumulative cash flow for payback:

$3,991
25.03%
18.40%
2.58
Years
2
3
($2,056)
$1,464
2.58

4
$4,600
-

5
$9,600
-

1 REFUNDING OPERATIONS (WEB APPENDIX 12C)


2
This example examines the issue of replacing existing debt with newly issued debt. At its core, this
issue raises two important questions. First, "Is it profitable to call an outstanding issue and replace it
with a new issue?" Second, even if refunding now is profitable, "Would the firm's expected value be
3 further increased if the refunding were postponed until a later date?"
4

5
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

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.

Input Data (in thousands of dollars)


Existing bond issue
Original flotation cost
Maturity of original debt
Years since old debt issue
Call premium (%)
Original coupon rate
After-tax cost of new debt

$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%

Cash flow schedule


Before-tax
Investment Outlay
Call premium on the old bond
Flotation costs on new issue
Immediate tax savings on old flotation cost expense
Extra interest paid on old issue
Interest earned on short-term investment
Total after-tax investment
Annual Flotation Cost Tax Effects: t=1 to 20
Annual tax savings from new issue flotation costs
Annual lost tax savings from old issue flotation costs
Net flotation cost tax savings
Annual Interest Savings Due to Refunding: t=1 to 20
Interest on old bond
Interest on new bond
Net interest savings

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
36 are:
37
38 Calculating the annual flotation cost tax effects and the annual interest savings
39
40 Annual flotation Cost Tax Effects
Annual Interest Savings
41 Maturity of the new bond
20
Maturity of the new bond
20
42 After-tax cost of new debt
5.4%
After-tax cost of new debt
5.4%
43 Annual flotation cost tax savings
$5
Annual interest savings
$1,080
44
45 NPV of flotation cost savings
$60
NPV of annual interest savings
$13,014
46
Hence, the net present value of this bond refunding project will be the sum of the initial outlay and the
47 present values of the annual flotation cost tax effects and interest savings.
48
49
50 Bond Refunding NPV = Initial Outlay +
PV of flot. costs +
PV of interest savings
51 Bond Refunding NPV =
($5,470)
+
$60
+
$13,014
52
53 Bond Refunding NPV =
$7,604
54

A
B
C
D
E
F
G
H
I
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
55 several external factors, including interest rate expectations.
56
57
58

CAPITAL BUDGETING WHEN ASSETS HAVE UNEQUAL LIVES (WEB APPENDIX 12F)
A firm is considering two mutually exclusive projects, a conveyor system (Project C) or a fleet
of forklift trucks (Project F), for moving materials. The cost of capital is 12%. We show a
traditional analysis in Part I and modified analyses in Parts II and III.
Two modifications can be used: The Replacement Chain method or the Equivalent Annual
Annuity (EAA) method. These two approaches always reach the same conclusion.

Figure 12F-1. Analysis of Mutually Exclusive Projects with Unequal Lives


I. Traditional Analysis
Project C
0
($40,000)
NPVC = $6,491

WACC =

12%

End of Period:
1
$8,000

Project F

2
3
$14,000 $13,000
IRRC = 17.5%

4
$12,000

5
$11,000

6
$10,000

End of Period:

0
($20,000)
NPVF = $5,155

1
$7,000

2
3
$13,000 $12,000
IRRF = 25.2%

Based on a traditional analysis, Project C appears to be the better investment. However, if the
firm chooses Project F, it would have the opportunity (which is a real option) to repeat the
investment 3 years from now. Therefore, we can reevaluate Project F using an extended life of
6 years. The time lines are shown below. Note that only F is changed. If the projects had had
lives of say 3 and 7 years, then it would have been necessary to extend the analysis out to a
common year, when both end, in this case to Year 21.
II. Replacement Chain Method for Adjusting for Unequal Lives
Project C: No change in the analysis
0
($40,000)
NPVC =

1
$8,000
$6,491

2
$14,000

WACC =

3
4
$13,000 $12,000
IRRC = 17.5%

12%

5
$11,000

6
$10,000

$7,000
$7,000
25.2%

$13,000
$13,000

$12,000
$12,000

Project F: Replacement Chain modification


0
($20,000)

1
$7,000

2
$13,000

($20,000)
NPVF =

$7,000
$8,824

$13,000

3
$12,000
($20,000)
($8,000)
IRRF =

On the basis of the replacement chain analysis, we see that Project F is the better choice.

III. Equivalent Annual Annuity (EAA) Method for Adjusting

The unequal life problem was first tackled by electrical engineers who were designing power
plants and distribution lines where they could use either assets with relatively low costs but
relatively short lives or high initial costs and longer lives. The facilities were expected to be
used forever (or at least as far as one could forecast), so the issue became this: Which choice
would result in the higher NPV over an infinite life?
The engineers decided to do an analysis where they took the varying annual cash flows and
converted them into a constant cash flow stream whose NPV was equal to, or equivalent to,
the NPV of the varying stream.
To apply the EAA method to Projects C and F, we first find the constant cash flow that has the
same NPV as the NPV we found using the traditonal analysis. For Project C, we need to find
the constant CF for 6 years that results in the same NPV.

III. Equivalent Annual Annuity (EAA) Method for Adjusting for Unequal Lives
For Project C, insert these values into a calculator: N = 6, I/YR = 12%, PV = 6491, FV = 0, and
then press PMT to find the constant annuity payment whose PV is $6,491. This payment is:
EAAC =
$1,578.78
Then do the same thing with Project F, using N = 3, I = 12%, PV = 5155, and FV = 0:
FV = 0, getting PMT
=
EAAF =

$2,146.28

We could get the same results using Excel's PMT function.


With the EAA method, we would choose the project with the higher EAA, Project F. We see
that the EAA and replacement chain methods result in the same choice, Project F.
The EAA method is easier to implement, but the replacement chain method is easier to explain
to senior managers. Also, it is easier to modify the replacement chain data to reflect cost
changes for the replaced assets and/or changes in the cash flows due to productivity
improvements, inflation, and so on.

APPENDIX 12F)

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

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