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Situation
Shrieves Casting Company is considering adding a new line to its product mix, and the capital budgeting
analysis is being conducted by Sidney Johnson, a recently graduated MBA. The production line would be
set up in unused space in Shrieves' main plant. The machinery’s invoice price would be approximately
$200,000, another $10,000 in shipping charges would be required, and it would cost an additional $30,000 to
install the equipment. The machinery has an economic life of 4 years, and Shrieves has obtained a special
tax ruling that places the equipment in the MACRS 3-year class. The machinery is expected to have a
salvage value of $25,000 after 4 years of use.
The new line would generate incremental sales of 1,250 units per year for 4 years at an incremental cost of
$100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The
sales price and cost are expected to increase by 3% per year due to inflation. Further, to handle the new line,
the firm’s net working capital would have to increase by an amount equal to 12% of sales revenues. The
firm’s tax rate is 40%, and its overall weighted average cost of capital is 10%.
(1.) Should you subtract interest expense or dividends when calculating project cash flow?
Answer: See Chapter 11 Mini Case Word Solutions
(2.) Suppose the firm had spent $100,000 last year to rehabilitate the production line site. Should this be
included in the analysis? Explain.
Answer: See Chapter 11 Mini Case Word Solutions
(3.) Now assume that the plant space could be leased out to another firm at $25,000 per year. Should this
be included in the analysis? If so, how?
Answer: See Chapter 11 Mini Case Word Solutions
(4.) Finally, assume that the new product line is expected to decrease sales of the firm’s other lines by
$50,000 per year. Should this be considered in the analysis? If so, how?
Answer: See Chapter 11 Mini Case Word Solutions
Analysis of New Expansion Project
Part I: Input Data
b. Disregard the assumptions in Part a. What is Shrieves' depreciable basis? What are the annual
depreciation expenses?
Remainin
g Book
Year % x Basis = Depr. Value
1 0.3333 $240,000 $79,992 $160,008
2 0.4445 240,000 106,680 53,328
3 0.1481 240,000 35,544 17,784
4 0.0741 240,000 17,784 0
c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include
inflation when estimating cash flows? See answer to part d.
e. Estimate the required net working capital for each year, and the cash flow due to investments in net
working capital.
g. Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR,
MIRR, and payback? Do these indicators suggest the project should be undertaken?
NPV $88,010
IRR 23.9% PV of InflowsTV of Inflows
$358,010 $524,162
Years
Find MIRR 0 1 2 3
Net Cash Flows ($270,000) $106,097 $118,995 $92,830
PV= ($270,000) TV =
To find MIRR, we could now find the discount rate that equates the PV and TV. But it is easier to use the
MIRR function.
MIRR = 18.0%
Payback = 2.5
h. What does the term ”risk” mean in the context of capital budgeting; to what extent can risk be quantified;
and when risk is quantified, is the quantification based primarily on statistical analysis of historical data or
on subjective, judgmental estimates?
Risk in capital budgeting really means the probability that the actual outcome will be worse than the
expected outcome. For example, if there were a high probability that the expected NPV as calculated above
will actually turn out to be negative, then the project would be classified as relatively risky. The reason for a
worse-than-expected outcome is, typically, because sales were lower than expected, costs were higher than
expected, and/or the project turned out to have a higher than expected initial cost. In other words, if the
assumed inputs turn out to be worse than expected then the output will likewise be worse than expected. We
use Excel to examine the project's sensitivity to changes in the input variables.
i. (1.) What are the three types of risk that are relevant in capital budgeting?
Answer: See Chapter 11 Mini Case Word Solutions
(2.) How is each of these risk types measured, and how do they relate to one another?
Answer: See Chapter 11 Mini Case Word Solutions
(3.) How is each type of risk used in the capital budgeting process?
Answer: See Chapter 11 Mini Case Word Solutions
Evaluating Risk: Sensitivity Analysis
Here we use an Excel "Data Table" to find the NPVs for changes in unit sales, salvage value, and WACC
holding other things constant--changing one variable at a time. This produces the sensitivity analys as
shown below.
We summarize the data tables and show the sensitivity analysis graph below:
Sensitivity Analysis
NPV ($)
180,000
Units Sold
160,000
140,000
120,000 Salvage
100,000 Value
80,000
60,000
WACC
40,000
20,000
0
-40% -30% -20% -10% 0% 10% 20% 30% 40%
Deviation from Base-Case Value
(3.) What is the primary weakness of sensitivity analysis? What is its primary usefulness?
Answer: See Chapter 11 Mini Case Word Solutions
k. Assume that Sidney Johnson is confident of her estimates of all the variables that affect the project’s cash
flows except unit sales and sales price: If product acceptance is poor, unit sales would be only 900 units a
year and the unit price would only be $160; a strong consumer response would produce sales of 1,600 units
and a unit price of $240. Sidney believes that there is a 25% chance of poor acceptance, a 25% chance of
excellent acceptance, and a 50% chance of average acceptance (the base case).
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 on NPV, and (2) it allows us to bring
in the probabilities of changes in the key variables.
Scenario Analysis
Squared Deviation
Scenario Probability Unit Sales Unit Price NPV times Probability
l. Are there problems with scenario analysis? Define simulation analysis, and discuss its principal
advantages and disadvantages.
Answer: See Chapter 11 Mini Case Word Solutions
Monte Carlo Simulation
Monte Carlo simulation is similar to scenario analysis in that different values of key input variables are used.
Unlike scenario analysis, Monte Carlo simulation draws the input values from specified probability
distributions and then computes the NPV. It repeats this process hundreds, or even thousands, of times. It
then averages the NPVs from each repetition.
m. (1.) Assume that Shrieves' average project has a coefficient of variation in the range of 0.2 to 0.4. Would
the new line be classified as high risk, average risk, or low risk? What type of risk is being measured here?
Answer: See Chapter 11 Mini Case Word Solutions
(2.) Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for
risk. Should the new line be accepted?
The CV of this project is 1.15, which is larger than the CV range of the firm's average project. Consequently,
this project is riskier than the firm's average project, so management should add 3% to the WACC to risk
adjust.
Cost of capital for average projects: 10%
Adjustment for risky projects: 3%
Risk adjusted cost of capital: 13%
NPV with risk-adjusted cost of capital: $65,350 (See the +30% WACC in the sensitivity analysis above.)
(3.) Are there any subjective risk factors that should be considered before the final decision is made?
Answer: See Chapter 11 Mini Case Word Solutions
e capital budgeting
uction line would be
be approximately
additional $30,000 to
s obtained a special
ected to have a
incremental cost of
n the first year. The
to handle the new line,
es revenues. The
h flow?
mportant to include
vestments in net
project’s NPV, IRR,
Year 4
$89,068
32,782
15,000
$136,850
4
$136,850
102,113
143,984
141,215
$524,162
4
$136,850
$184,772
can risk be quantified;
of historical data or
er?
SALVAGE
NPV
$88,010
$84,936
86,473
88,010
89,546
91,083
lness?
an one variable at a
2) it allows us to bring
to find the project’s
its principal
roject. Consequently,
o the WACC to risk
vity analysis above.)
decision is made?
$200,000
$10,000
$30,000
4
$25,000
40%
10%
1,250
$200
$100
12%
3%
$200,000
$10,000
$30,000
4
$25,000
40%
10%
1,600
$240
$100
12%
3%
$200,000
$10,000
$30,000
4
$25,000
40%
10%
900
$160
$100
12%
3%
$200,000
$10,000
$30,000
4
$25,000
40%
10%
1,250
$200
$100
12%
0%
Scenario Summary
Current Values: Base Case Best Case
Changing Cells:
$D$36 $200,000 $200,000 $200,000
$D$37 $10,000 $10,000 $10,000
$D$38 $30,000 $30,000 $30,000
$D$39 4 4 4
$D$40 $25,000 $25,000 $25,000
$D$41 40% 40% 40%
$D$42 10% 10% 10%
$D$43 1,250 1,250 1,600
$D$44 $200 $200 $240
$D$45 $100 $100 $100
$D$46 12% 12% 12%
$D$47 3% 3% 3%
Result Cells:
$C$113 $88,030 $88,030 $278,965
$C$114 23.9% 23.9% 48.3%
Notes: Current Values column represents values of changing cells at
time Scenario Summary Report was created. Changing cells for each
scenario are highlighted in gray.
Worst Case Base-but forget inflation
$200,000 $200,000
$10,000 $10,000
$30,000 $30,000
4 4
$25,000 $25,000
40% 40%
10% 10%
900 1,250
$160 $200
$100 $100
12% 12%
3% 0%
($48,514) $78,387
1.0% 22.7%
Section 11.7 Scenario Analysis
Monte Carlo simulation is similar to scenario analysis in that different values of key inputs are used Unlike scenario
analysis, Monte Carlo simulation draws a trial set of input values from specified probability distributions and then
computes the NPV for this trial. This process is repeated for hundreds, or even thousands, of trials, with key results (
NPV) saved from each trial. After running the number of desired trials, the NPVs from the trials can be averaged to
estimate the project's expected NPV; the trial results can also be used to provide a histogram showing the project's
possible outcomes.
The green area below is the same project as in the mini case, but we have replaced the inputs for units sold and sales
price with random variables drawn from normal distributions with the expected values and means shown next to the
inputs. Notice that each time the sheet makes a calculation, the values for unit sales, sales price, and NPV change (Hi
you can make the sheet calculate by hitting the F9 key).
Here is a tip for simulating a project analysis. If you have already done the analysis and it is in a different worksheet, s
how many rows it takes. Delete the green area below and add enough rows so that there will be room for your previou
analysis. For example, this model was in the "Model" tab in the file Ch 11 Mini Case.xls, rows 33-132. We went into tha
selected Rows 32-135, copied them, and then pasted them into Rows 32-135 of this Worksheet. Because we pasted th
into the same row numbers from which we copied them, all the formula references remained correct. We then edited t
worksheet.
c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include
inflation when estimating cash flows? See answer to part d.
e. Estimate the required net working capital for each year, and the cash flow due to investments in net working
capital.
g. Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR,
MIRR, and payback? Do these indicators suggest the project should be undertaken?
g. Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR,
MIRR, and payback? Do these indicators suggest the project should be undertaken?
NPV ($1,862)
IRR 9.7% PV of Inflows
TV of Inflows
$260,043 $380,729
Years
Find MIRR 0 1 2
Net Cash Flows ($261,905) $78,005 $90,915
PV= ($261,905)
To find MIRR, we could now find the discount rate that equates the PV and TV. But it is easier to use the MIRR functio
MIRR = 9.8%
Payback = 3.3
We use a Data Table to perform the simulation (the Data Table is below, shaded bright yellow). When the Data Table is
updated, it will insert new random variables for each of the inputs we allow to change in Panel A above, run the analys
Panel C above, and then save the NPV for each trial (we also save the input variables for each trial so that we can veri
that they are behaving as we expect). We set the first column of the Data Table (the variable to be changed in each row
numbers from 1-100. We don't really use these numbers anywhere in the analyis, but if we tell the Data Table to treat t
as the Column inputs, Excel will recalculate all items in the Data Table, including the random inputs and the resulting
In other words, we "trick" Excel into doing a simulation. We tell Excel to insert each of the Column inputs in the Data T
into the cell immediately below this box. This cell isn't linked to anything else, but each time Excel updates a row of th
Data Table, all the random values will be updated.
Column input cell to "trick" Excel into updating random variables in Data Table: 1
Excel normally updates all values in a Data Table each time any cell that is related to the Data Table changes. In our ca
we have random variables in the Data Table, so each time any cell in the worksheet makes a calculation, the Data Tabl
updated. If the Data Table has many rows, updating it can take up to 20 or 30 seconds. With only 100 rows, it updates
quickly. But if it bothers you, you can set the worksheet to do automatic calculation except for data tables.
You don't need to change anything in this section. It will be updated automatically if you do a simulation. The summa
the simulation results and the histogram are based on the simulation trials n the Data Table below and are updated
automatically when you do a simulation. You can do an updated simulation by hitting the F9 key.
Median $79,075
Probability of NPV > 0 85.0%
Coefficient of variation 0.96
Probability
NPV ($)
Output of Simulation in Data Table
Sales
Price Per
Trial Number Units Sold Unit NPV
1,042 $175 ($1,862)
1 1042.3352 175.12407 123824.3193
2 1042.3352 175.12407 137989.4427
3 1042.3352 175.12407 81798.65679
4 1042.3352 175.12407 32983.44956
5 1042.3352 175.12407 -48923.0852
6 1042.3352 175.12407 -41661.7729
7 1042.3352 175.12407 90113.59846
8 1042.3352 175.12407 84805.41575
9 1042.3352 175.12407 160783.9865
10 1042.3352 175.12407 78951.18086
11 1042.3352 175.12407 106216.959
12 1042.3352 175.12407 43627.84222
13 1042.3352 175.12407 -40666.2731
14 1042.3352 175.12407 35864.88279
15 1042.3352 175.12407 -31136.3167
16 1042.3352 175.12407 28568.72522
17 1042.3352 175.12407 97123.04419
18 1042.3352 175.12407 67192.97753
19 1042.3352 175.12407 104724.1007
20 1042.3352 175.12407 173703.8977
21 1042.3352 175.12407 -75415.0443
22 1042.3352 175.12407 -35317.4117
23 1042.3352 175.12407 -34635.7491
24 1042.3352 175.12407 115168.7444
25 1042.3352 175.12407 117222.6638
26 1042.3352 175.12407 118025.0112
27 1042.3352 175.12407 78114.66689
28 1042.3352 175.12407 -15373.2174
29 1042.3352 175.12407 46495.84202
30 1042.3352 175.12407 166278.5131
31 1042.3352 175.12407 33829.89946
32 1042.3352 175.12407 139574.4867
33 1042.3352 175.12407 49150.02186
34 1042.3352 175.12407 11448.15976
35 1042.3352 175.12407 -77884.6116
36 1042.3352 175.12407 127639.9983
37 1042.3352 175.12407 204722.4073
38 1042.3352 175.12407 30100.60604
39 1042.3352 175.12407 33951.18838
40 1042.3352 175.12407 181546.0784
41 1042.3352 175.12407 -13198.6585
42 1042.3352 175.12407 113544.428
43 1042.3352 175.12407 114680.8247
44 1042.3352 175.12407 56297.82754
45 1042.3352 175.12407 167515.2268
46 1042.3352 175.12407 45758.72399
47 1042.3352 175.12407 124624.0997
48 1042.3352 175.12407 36276.83007
49 1042.3352 175.12407 54804.42634
50 1042.3352 175.12407 121567.5269
51 1042.3352 175.12407 70621.02705
52 1042.3352 175.12407 104428.9432
53 1042.3352 175.12407 -4859.13674
54 1042.3352 175.12407 98733.66327
55 1042.3352 175.12407 32555.49382
56 1042.3352 175.12407 8102.185506
57 1042.3352 175.12407 214637.592
58 1042.3352 175.12407 131130.5873
59 1042.3352 175.12407 128817.377
60 1042.3352 175.12407 51147.10197
61 1042.3352 175.12407 62998.5904
62 1042.3352 175.12407 -106575.772
63 1042.3352 175.12407 79198.60303
64 1042.3352 175.12407 103395.8958
65 1042.3352 175.12407 73553.52838
66 1042.3352 175.12407 74648.71204
67 1042.3352 175.12407 132916.7079
68 1042.3352 175.12407 32822.07827
69 1042.3352 175.12407 57931.55406
70 1042.3352 175.12407 130767.5859
71 1042.3352 175.12407 92496.44211
72 1042.3352 175.12407 84358.52114
73 1042.3352 175.12407 -29111.3909
74 1042.3352 175.12407 43009.35728
75 1042.3352 175.12407 253060.239
76 1042.3352 175.12407 -19521.9971
77 1042.3352 175.12407 182787.8274
78 1042.3352 175.12407 179070.7135
79 1042.3352 175.12407 138981.2121
80 1042.3352 175.12407 20343.73711
81 1042.3352 175.12407 107722.534
82 1042.3352 175.12407 -13115.7863
83 1042.3352 175.12407 55021.58275
84 1042.3352 175.12407 32855.00833
85 1042.3352 175.12407 65196.59771
86 1042.3352 175.12407 171586.4605
87 1042.3352 175.12407 93291.71573
88 1042.3352 175.12407 164658.9499
89 1042.3352 175.12407 43661.62345
90 1042.3352 175.12407 219251.3213
91 1042.3352 175.12407 41732.71942
92 1042.3352 175.12407 118594.1771
93 1042.3352 175.12407 331343.9172
94 1042.3352 175.12407 167244.4925
95 1042.3352 175.12407 31945.08497
96 1042.3352 175.12407 10364.50762
97 1042.3352 175.12407 133735.5189
98 1042.3352 175.12407 245419.0037
99 1042.3352 175.12407 163215.1669
100 1042.3352 175.12407 132183.0317
1/1/2016
($1,862)
re the annual
Remaining
Book
Value
$160,800
52,800
16,800
0
important to include
Year 4
1,042
$191.36
$109.27
$199,461
113,896
16,800
$68,765
27,506
$41,259
16,800
$58,059
Year 4
$199,461
23,935
$64,244 $58,059
(696) 23,935
15,000
$63,548 $96,994
Years
3 4
$63,548 $96,994
69,903
110,007
103,825
TV = $380,729
Years
3 4
$63,548 $96,994
($29,436) $67,558