PRINTCO

ItisnowJuly1988.Printco,aleadingelectronicsfirm,isconsideringtheinstallationofa
new productionline tomanufacture low costlaserprinters. Ifa"go"decisionis made,
PrintcomustspendR2000000topurchasenewequipmentforthelineplusanotherR200
000foritsinstallation.Theinstallationchargeswouldbeaddedtothepurchaseprice,then
capitalizedanddepreciated.
Astudyconductedlastyearbyoutsideconsultants,atacostofR50000hasdeterminedthat
anold,fullydepreciatedpartswarehousethatthefirmemptiedlastyearwouldbeasuitable
placetohousethenewassemblyline.Also,acheckwithatopcommercialpropertyagent
hasrevealedthat,shoulda"nogo"decisionbemade,thewarehousecouldbesoldtonetR80
000aftercommissions,fees,andalltaxes.SincePrintcohasnootheruseforthebuilding,it
wouldbesoldiftheCompanydecidesnottogoforwardwiththelaserprinter.
Thenewequipmentwouldmostprobablybedepreciatedfullyoverthreeyearsat50%inthe
firstyear,30%inthesecondand20%inthethirdyear.However,theestimatedeconomic
lifeoftheequipment(andtheproject)is5years.
The project would require an increase in the level of Printco's gross working capital,
primarilyforrawmaterialandsparepartsinventories.However,theexpectedincreaseinraw
materialpurchaseswouldalsoincreasePrintco'slevelofcreditors.Theneteffectwouldbea
R20000increaseinnetworkingcapital.
Although the investment outlays would occur throughout 1989, it is Printco's policy to
assumethatallcashflowsoccuronDecember31oftheyearinwhichtheyoccur.Thus,the
net investment outlay would constructively occur on December 31, 1988. Similarly, all
operatingcashflowsareassumedtooccurattheendofeachyear,socashflowsattributable
tooperationsfrom1989through1994wouldconstructivelyoccuronDecember31,1989,
andsoon.
Printco's engineers estimate that the new assembly line could be installed and ready for
operationsonJanuary1,1989.SalesofR3840000(3200units@R1200/unitin1989
rands)areestimatedfor1989iftheeconomyremainsatitscurrentlevelofaveragegrowth.
Unitsalesareexpectedtobeflatoverthe5yearlifeoftheassemblyline,butprices,and
hencerevenues,areexpectedtoincreasewithinflation,whichisestimatedat15percentper
yearoverthelifeoftheproject. Fixedcostsotherthandepreciationwouldbeaconstant
R300000peryear,andvariablecostsareexpectedtobe75percentofrandsales.Printco's
marginaltaxrateis40%,whileitscostofcapitalforanaverageriskprojectis18%.
Attheendoftheproject's5yearoperatinglife,theplantwouldbecloseddown. Printco
planstodisassembletheline,demolishthebuilding,anddonatethelandasapark.Thenet
costofclearingthesitewouldbeaboutequaltothetaxsavingsresultingfromthecharitable
contribution.Theassemblylineequipment,ontheotherhand,wouldbesoldatitsestimated
salvagevalue,whichwoulddependonthestateoftheeconomy.Thebestestimatesfromthe
engineeringdepartmentvaryfromalowofR0uptoahighofR1000000.Iftheeconomy
weresluggish,therewouldbevirtuallynodemandfortheusedequipmentandthescrap
valuewouldjustoffsettheremovalcosts. Withanaverageeconomy,thesalvagevalueis
estimatedatR800000beforetaxes. Finally,inastrongeconomy,thedemandwouldbe
muchgreater,anditisestimatedthatthemachinerywouldbringR1000000intheresale
market.
Theconsensusoftheengineers andcostaccountants,whohavethoroughlyreviewedthe
investment outlays, is that there is virtually nouncertainty about thosefigures, andthey
believethefixedandvariableoperatingcostdataarealsoreliable.However,thenumberof
units sold, and hence sales, depends uponthe state ofthe economy. If the economy is

sluggishin1989,salescouldbeonly2000units.Conversely,astrongeconomycouldboost
firstyearsalesto5500units.
Forcapitalbudgetingpurposes,unitsalesareassumedtoremainateithertheaverage,the
depressed, or the elevated firstyear level for the entire 5 years, while rand sales would
increasebytheinflationadjustments. Therehas,however,beensomedebateonthispoint
amongcapitalbudgetingstaffmembers.Printcoisforecastinga60percentprobabilityofan
averageeconomy,butthereisa30percentchanceofaslowdownanda10percentchanceof
aboom.

QUESTIONS
Printco'scapitalbudgetingdepartment'sbasecasemodelforthisprojectisfiledonthecase
disketteunderthefilenamePRINCO_S. Setituponyourcomputerandthenanswerthe
followingquestions:
1.

Undertheassumptionthattheprojecthasthesameriskasthefirm's"average"project,
thebasecaseNPVandIRRhavebeencalculatedusingexpectedvaluesforbothunit
salesandsalvagevalue.InterpretthemeaningofthebasecaseNPVofR193020.Is
thisNPVactuallyachievableunderthestrictassumptionsofthecase?Notealsothat
theprojecthasaccountinglossesinthefirstyear.Explainthemeaningofthenegative
taxesshown.Wouldthistreatmentbeappropriateforanewcompanythatwouldhave
justthisoneproject?

2.

Usingsalesandsalvagevalueestimates forastrongandforasluggisheconomy,
performascenarioanalysistofindtheproject'sbestcaseandworstcaseNPVandIRR
valuestogowithyourbasecasevalues.Interprettheresultsofthescenarioanalysis.

3.

DeterminetheNPVandIRRusingmostlikely(asopposedtoexpected)valuesfor
bothsalesandsalvagevalue.Usethisresult,alongwiththebestandworstcaseNPVs
andIRRsfromQuestion2,tofindanexpectedNPVandIRRbaseduponthethree
NPVsandIRRs,andtheirprobabilitiesofoccurrence.Shouldthisresultbethesame
astheNPVinQuestion1?

4.

Discussproblemsthatresultfromusingdiscreteprobabilitieswhen,inreality,thereis
aninfinitesetofpossibleoutcomes.Isaprobabilityanalysisequallyusefulformany
smallprojectsproposedbyalargefirmasopposedtoonehugeprojectconsideredbya
smallfirm?

5.

DeterminethesensitivityofNPVtochangesin(a)unitsalesand(b)salvagevalue
projections. Toconducttheseanalyses,assumethatunitsalesandsalvagevalues
could vary from base case values of 3 000 for unit sales and
580000forsalvagevaluebyplusorminus10percent,20percent,and30percent.
Whenyouchangeunitsales,holdsalvagevalueconstantatthebasecasevalue.Then
changesalvage value andhold unit sales atthe basecase value. What does this
analysisimplyabouttheimpactofunitsalesandsalvagevalueestimatesonNPV?
(Hint:PartiallycompletedSensitivityTablesareincludedthatsimplifythesensitivity
analyses).

6.

Discuss how the firm's director of capital budgeting could use the information
developedthusfartoassesstheriskinessoftheproject. Assumethatthedirector
concludesthattheprojectisriskierthanaverage,andthatitisPrintco'spolicytoadd4
percentagepointstothefirm'scostofcapitalforprojectswithaboveaveragerisk,and
then evaluate them at base case input values. With risk thus considered, should
Printcoacceptorrejecttheproject?Why?

7.

Nowassumethatiftheeconomyispoorduringthefirstyearofoperation,theproject
willbeabandoned(attheendof1989).Themachinery,withmuchlesswearandtear,
wouldsellforR1500000.Findtheproject'sNPVandIRRundertheassumptionof
abandonment.Howdoesthisinformationaffecttheriskinessoftheproject?

8.

ThereareTHREEtypesofriskinherentincapitalprojects: (1)projectortotalrisk
(2)companyriskand(3)market,orbeta,risk.Whichtypeofriskisbeingassessed
here? Discuss the three types of risk and their relevancy to capital budgeting
decisions.

9.

Now assume that the director of capital budgeting determines that the project's
estimatedcashflowsarenegativelycorrelatedwiththeestimatedcashflowsofthe
firm'sexistingprojects. Howwouldthisinformationaffecttheproject'sriskiness?
Wouldyouranswerbethesameiftheproject'scashflowshadbeen(contrarytothe
actualcase)negativelycorrelatedwithGNP?

10.

Oneoftheassumptionsusedtodevelopthemodelwasthatiffirstyearsaleswere
goodorbad,thissameconditionwouldprevailduringthenextfouryears. Thisis
calledintertemporaldependence. Analternativewouldbetoassumeintertemporal
independence,whichmeansthatsalesinYeartarenotdependentuponYeart1sales.
Onecould,ofcourse,alsoassumeapartialdependenceofsalesinYeartonYeart1
sales. Otherthingsheldconstant,wouldtheprojectberiskierunderintertemporal
dependenceorindependence?Doyouagree,basedonotherstatementsmadeinthe
case,thattheassumptionofintertemporaldependenceismostlogical?

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