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CASE INFORMATION

Purpose

This case, which in all aspects is identical to Case 13, extends the capital budgeting analysis begun in Case 14 [Robert Montoya (A)]. Either Case 13 or Case 15, but not both, should be assigned. Whereas Case 14 focuses on cash flow estimation and develops the base case ranking criteria, Case 15 extends the analysis to include risk. This case can be worked by hand, but it is ideal for demonstrating the power and usefulness of computer models.

Time Required

Approximately 4 hours of student preparation are required if the case is worked by hand. Only 2-3 hours are required if the Lotus model is used. An additional hour will be required if the case must be written up and handed in.

Complexity

C--relatively complex.

Flexibility

This case can stand alone, but we generally assign it immediately following Robert Montoya (A). When it is used in this manner, the students are familiar with the cash flow estimates prior to conducting the risk analysis. When we were giving the cases their final "class testing" before sending the book to the publisher, we had students read Robert Montoya (A), and we presented the answer in class as a lecture. Then we had our students work Robert Montoya (B) in the regular manner.

The model for this case (filename CASE-15I), which is almost identical to the model for Case 14, calculates the red wine project's net cash flows, and then it calculates NPV, IRR, MIRR, and Payback. (We tell our students that they may use their completed Case 14 models if they desire.) The model is particularly useful for performing scenario and sensitivity analyses--just change an input data item, and the revised output is given almost instantaneously. The model's INPUT DATA and KEY OUTPUT sections for the base case are shown below:

INPUT DATA: Initial Investment: Price Freight Installation Change in NWC $2,200,000 $80,000 $120,000 $100,000 NPV IRR MIRR Payback $566,857 19.8% 15.8% 2.6 KEY OUTPUT:

Operating Flows and Inflation Rates: Sales volume Year 0 sales price Operating cost % Price inflation Cost inflation 100,000 $40.00 80.0% 5.0% 2.0%

SV, Taxes, and C of C: Salvage value Tax rate Cost of capital $150,000 40% 10%

Model Use

We typically supply students with one of the partially completed student versions of the model. Case Questions 2 and 3 are ideally suited to illustrate the power of spreadsheet models. The sensitivity analysis can be done rather easily by simply changing an input variable, observing the related output values, and then going on to the next input variable change. However, if students are familiar with the Data Table feature of Lotus, this is a good time to illustrate its use. Therefore, we set up three Data Tables in the lower third of the MODEL-GENERATED DATA section. If you are not at all familiar with Data Tables, we suggest that you try to follow our brief instructions as shown adjacent to the 1993 The Dryden Press

All rights reserved.

Case 15-3

tables in the model and set up the tables, but if you need more help, read over the relevant section of the Lotus manual or the write-up in the Dryden Press book; Finance with Lotus 1-2-3: Text and Models by Eugene F. Brigham, Dana A. Aberwald, and Louis C. Gapenski. Note, though, that the Data Tables for NPV are complete in the model, and they have been used to set up a sensitivity analysis graph. Press the F10 key to view the graph; then press any key to return to the spreadsheet. Both the Data Tables and the graph must be modified to show the IRR sensitivity or other sensitivities. If your school has the @RISK Lotus 1-2-3 add-in program, this is an ideal case with which to use it. @RISK permits students to do a full-scale Monte Carlo simulation analysis, and to develop all the risk parameters and graphics inherent in such an analysis. We did not include such an analysis in our model, but it would be easy to do if you have access to @RISK and know how to use it. We have included some @RISK output in the solution to Question 5.

See completed versions of Tables 1, 2, and 3 at the end of this solution; students will probably present their answers by replacing the X's in the tables as presented in the case. Additional (often repeated) numerical answers are given below. 2. Change from Base Level ___________ -30% -20 -10 0 +10 +20 +30 NPV after Indicated Change: Quantity Salvage Value k ___________ _____________ ________ ($85,946) $548,415 $782,468 131,655 554,563 707,951 349,256 560,710 636,123 566,857 566,857 566,857 784,458 573,004 500,034 $1,002,059 579,151 435,541 $1,219,660 585,298 373,272

3.

Worst case NPV = -$85,946. Most likely case NPV = $566,857. Best case NPV = $1,219,660. E(NPV) = $566,857. _NPV = $461,601. CVNPV = 0.8. NPV (@ 13%) = $373,272. NPV (@ 7%) = $782,468.

7.

8.

a.

ksp = 20.0%. WACCp = 13.0%. PV costsW = $1,743,426. PV costsC = $1,746,056. PV costsW (@ 7%) = $1,812,158.

9.

a.

b.

Question 1

a. Risk analysis is important in all financial decisions. The higher an asset's risk, the higher its required rate of return. This is as true for individual investors considering securities investments as it is for a company considering a capital investment. (1) Here are the three types of project risk: (a) Stand-alone risk is the project's total risk if it were operated independently. Stand-alone risk ignores both the firm's diversification among projects and investors' diversification among firms. Stand-alone risk is normally measured by the project's standard deviation or coefficient of variation of NPV or IRR. Within-firm risk is the total riskiness of the project within the firm's portfolio of assets. It reflects the project's contribution to the firm's total risk, and it is a function of both the project's standard deviation of returns and its correlation with the aggregate returns of the rest of the firm. Market risk is the riskiness of the project to a well-diversified investor. It is a function of the project's standard deviation of returns and its correlation with the returns on the market. It is measured by the project's beta coefficient relative to the stock market; that is, the project's market beta.

b.

(b)

(c)

(2)

Since management's primary goal is shareholder wealth maximization, the most relevant risk for capital projects

is market risk. However, other parties such as creditors, customers, suppliers, and employees are affected by a firm's total risk, and hence a project's within-firm risk should not be completely ignored. Also, within-firm risk is the relevant risk for not-for-profit firms such as some hospitals. (3) Unfortunately, the easiest type of risk to measure, by far, is a project's stand-alone risk. Thus, firms often focus on this type of risk when making capital budgeting decisions. Using stand-alone risk does not necessarily lead to poor decisions, because most projects that a firm undertakes are in its core business, and in this situation, a project's stand-alone risk is likely to be highly correlated with its within-firm risk. Further, most projects' returns are likely to be highly correlated with the economy as a whole, so a project's stand-alone risk is normally highly correlated with its market risk.

(4)

Question 2

a. Sensitivity analysis measures the impact of changes in a particular variable, say sales quantity, on a project's output variable, say NPV. To perform such an analysis, all variables are fixed at their expected values except one. Then, this variable is changed, often by fixed percentages, and the resulting impact on NPV or IRR is noted. We used the Lotus 1-2-3 model to develop the sensitivities given here in tabular form:

Variable Change from Base Level ___________ -30% -20 -10 0 +10 +20 +30 NPV after Indicated Change: Quantity ___________ ($85,946) 131,655 349,256 566,857 784,458 $1,002,059 $1,219,660 Salvage Value _____________ $548,415 554,563 560,710 566,857 573,004 579,151 585,298 k ________ $782,468 707,951 636,123 566,857 500,034 435,541 373,272

b.

c.

The sensitivity curves intersect at the base case value (0% change) and the most likely NPV of $566,857. Since all other variables are set at their expected values, a zero percent change for the variable being analyzed is

the base case. (2) The plots for sales quantity and salvage value are upward sloping, indicating that higher variable values lead to higher NPVs. Conversely, the plot for the cost of capital is downward sloping--higher capital costs lead to lower NPVs. The sales quantity plot is much steeper than the salvage value plot. This indicates that NPV is much more sensitive to a given percentage change in sales quantity than to changes in salvage value, so an estimating error in forecasted unit sales could lead to a larger error in estimated NPV than an estimating error in salvage value. (This should be obvious because sales quantity affects revenues, which affect cash flows in every year, but salvage value affects only the Year 4 cash flow. Further, the revenue amount is much larger than the salvage value amount, and hence equal percentage changes produce much larger dollar changes in revenues than in salvage value.) Steeper sensitivity lines indicate greater risk. Thus, in comparing two projects, the one with the steeper lines is considered to be riskier. Errors in estimating variables with steep sensitivity lines lead to large errors in estimated NPV.

(3)

(4)

ROBERT MONTOYA

1.3 1.2 1.1 1 ) s n o i l l Vi PM N ( 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 -0.1 -30% -20% -10% Base case Input Variable Variability Salvage Value +10% +20% +30% Sensitivity Analysis

Unit Sales

d.

One important weakness of sensitivity analysis is that it does not incorporate any information on the possible magnitude of the forecast errors. Thus, a sensitivity analysis might indicate that a project's NPV is highly sensitive to the sales quantity forecast, and hence suggest that the project is quite risky, but if the project's sales quantity is fixed by a long-term sales contract, then sales may contribute little to the project's risk. A second weakness is that sensitivity analysis does not consider either within-firm or market diversification--it only gives an indication of the project's total risk, and to the extent that it is possible to eliminate some of that risk through diversification, sensitivity analysis overstates the project's risk. Finally, sensitivity analysis focuses on one variable at a time, whereas a project's risk depends on not only the uncertainty of each input variable, but also on how the uncertain variables interact with one another.

The primary advantages of sensitivity analysis are: (1) it is easy to perform and to explain to decision makers, and (2) it clearly identifies those variables that have the greatest impact on NPV, so a company's forecasting effort can be focused on those variables that have the greatest potential for causing bad results.

Question 3

We ran the Lotus model with unit sales set on 70,000, 100,000, and 130,000 to develop the scenario results. Here are the NPVs, IRRs, and MIRRs for the three cases:

Prob. 0.25 0.50 0.25 Case Worst -$ NPV 85,946 566,857 1,219,660 IRR 8.4% 19.8 30.2 MIRR 9.0% 15.8 21.5

= = =

The project's expected NPV is $566,857: E(NPV) = 0.25(-$85,946) 0.25($1,219,660) = $566,857. The standard deviation of NPV is $461,601: _NPV = [0.25(-$85,946 - $566,857)2 + 0.50($566,857 $566,857)2 + 0.25($1,219,660 - $566,857)2]1/2 = [$213,075,878,405]1/2 = $461,601. The project's coefficient of variation is 0.8: _NPV $461,601 CVNPV = ______ = ________ _ 0.80. E(NPV) $566,857 The corresponding similarly. measures for IRR and MIRR were obtained + 0.50($566,857) +

Question 4

Scenario analysis has two primary advantages: (1) Scenario analysis examines several possible outcomes, usually the worst case, most likely case, and best case. Thus, several input variables can be changed at once, whereas only one variable is changed in a sensitivity analysis. (2) Computationally, scenario analysis is relatively easy to perform. On the other hand, scenario analysis has two major disadvantages: (1) Typically, scenario analysis considers only three possible states of the economy, although more could be considered, say, 5 or 7. But, the world is very complex, and most projects have an almost infinite number of possible outcomes. Thus, scenario analysis takes a very simplistic view of a project's profitability distribution. (2) The results of the scenario analysis are only as good as the estimates that go into it. If managers cannot develop good estimates for the best and worst case inputs, the scenario analysis loses its value.

Question 5

Monte Carlo simulation analysis is a type of scenario analysis in which the uncertain cash flow variables are entered as continuous distribution parameters rather than as point values. Then, the computer uses a random number generator to select values for the uncertain variables on the basis of their designated distributions. Once all the variable values have been selected, an NPV is calculated. The process is repeated many times, say 500, with new values selected from the distributions for each run. The end result is a probability distribution of NPV based on 500 observations. The software can graph the distribution as well as print out summary statistics such as expected NPV and _NPV.

Ep c d x e te Rs lt e u= .5 6 2 6 6 91 2% 0

Smlin = ap g

L tinHp r u e a y ec b # r ls Tia = 10 00

1% 6

1% 2

8 %

4 %

Simulation provides the decision maker with a much better idea of the profitability of a project than does scenario analysis, because simulation incorporates many more possible states of the economy. The decision maker can also easily determine how great the chances are for a certain project to reach a predetermined cutoff point. To demonstrate Monte Carlo simulation, we used @RISK, a Lotus add-in, to run a simulation on this case. Figure 2 shows the resulting "regular" NPV distribution. To simplify the simulation, we used only one uncertain variable, unit sales, which was specified as a normal distribution with a mean of 100,000 units and standard deviation of 10,000. The following tabular data were generated by the simulation:

@RISK: Simulation Statistic 09-Jul-1992 Worksheet: CASE-15I NPV (in Cell F25)

========================== ============= Expected/Mean Result = Maximum Result = Minimum Result = Range of Possible Results = Chance of Positive Result = Chance of Negative Result = Standard Deviation = Skewness = Kurtosis = Variance = 566921.6 1306548 -119128.6 1425677 99.6 0.4 217490.3 0.008426969 2.976548 47302040000

0 0 1 1000

Percentile Probabilities (Chance <= Shown Value) ========================== 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% -119128.6 208473.6 286876.3 340549.5 383457.2 419419.8 452533 482890.6 511187.7 539446.4 566752 594037.9 621920.8 650699.9 680567.3 713040 749958.4 791760.3 844853.4 924006.7 1306548

Probabilities for @RISK Selected Values: ========================== Value #1= Probability >= Value #1= Value #2= Probability >= Value #2= Value #3= Probability >= Value #3= Value #4= Probability >= Value #4= Value #5= Probability >= Value #5= Value #6= Probability >= Value #6= Value #7= 150000 97.2 300000 89 450000 70.4 600000 44 750000.1 20 900000.1 6.3 1050000

Probability >= Value #7= Value #8= Probability >= Value #8= Value #9= Probability >= Value #9= Value #10= Probability >= Value #10= Value #11= Probability <= Value #11= Value #12= Probability <= Value #12= Value #13= Probability <= Value #13= Value #14= Probability <= Value #14= Value #15= Probability <= Value #15= Value #16= Probability <= Value #16= Value #17= Probability <= Value #17= Value #18= Probability <= Value #18= Value #19= Probability <= Value #19=

1.3 1200000 0.2 1350000 0 1500000 0 -49999.99 0.3 -99999.99 0.1 -150000 0 -200000 0 -250000 0 -300000 0 -350000 0 -400000 0 -450000 0

@RISK also permits us to specify various degrees of correlation between different input variables--for example, we could set up the model so that if unit sales are high, indicating a strong demand for the product, then the sales price will also be high. In other words, the sales price distribution is conditional on the level of demand. Similarly, we could specify that sales in Year t are conditional on sales in Year t-1, indicating that good initial sales portend good product acceptance and hence high subsequent-year sales. Alternatively, if economic logic suggests it, we could set a zero correlation between sales from one year to the next, which would indicate that sales fluctuations are strictly random. A few years ago it was impossible to run a simulation analysis except on a mainframe computer. Now, however, excellent software (IFPS and @RISK) are available for use with PCs. It would be relatively easy to modify this case and then analyze it with the @RISK program. Although simulation analysis is technically refined, its usefulness is limited by management's ability to accurately specify the variables' probability distributions, and, especially, the correlations among the variables and the correlations of the values of a variable such as unit sales over time (that is, does the sales level in Year 1 affect the likely sales in Year 2?). If managers are unable to specify probability distributions and correlation

coefficients with much confidence, then the results of simulation analyses will be of limited value. Note, though, that managers' abilities in this regard depend on the type of project involved, the availability of historical data, and the managers' training. Computer technology is making data increasingly available, and managers are becoming more and more knowledgeable about the use of these data, and as this occurs, the usefulness and the actual use of simulation analysis will grow. Recognize also provides a decision risky than average, return is sufficient that neither scenario nor simulation analysis rule--they may indicate that a project is more but they do not indicate whether the project's to compensate for its risk.

Finally, remember that both scenario and simulation analyses as they are normally conducted focus on a project's stand-alone risk, which is not the most relevant risk to be considered. Still, in spite of these weaknesses, simulation is still a powerful tool, and as PCs and related software proliferate, its use will undoubtedly expand.

Question 6

a. The red wine project has a coefficient of variation (CV) of NPV of 0.80, and hence it falls into the high risk category, according to Robert Montoya's classifications (an average project has a CV of NPV in the range of 0.25 to 0.50). The CV measures a project's stand-alone total risk--it is merely a measure of the variability of returns (as measured by NPV) about the expected return. If the wine project's cash flows are highly correlated with the aggregate cash flows of the firm, which is often a reasonable assumption, then the project would also have high within-firm risk. b. If the red wine project had been on-going, it would be possible to use regression analysis to calculate its beta visa-vis the firm's other products. In the present case, though, that is not possible. Still, it would appear that the project's within-firm risk would be high because sales of this product are likely to be influenced by the same factors that affect sales of the company's other products. Thus, its within-firm beta is probably high, and this product's standalone risk is high. On the other hand, it might be that sales of cabernet sauvignon, red wine are negatively correlated with sales of other wines; this might be true if it were replacing more robust wines in the marketplace. In that event, the new project's within-firm risk might actually be quite low--under this scenario, the new project would be a type of insurance policy against a shift in market preferences. 1993 The Dryden Press

All rights reserved.

Case 15-14

c.

If the project's cash flows were totally uncorrelated with the firm's aggregate cash flows, then accepting the project would reduce the total risk of the firm, and hence the riskiness of the project would be less than that indicated by its standalone risk. If the project's cash flows were negatively correlated with the firm's aggregate cash flows, then the project would reduce the total risk of the firm even more, and the project would be even less risky. Wine is generally regarded as a luxury good--people drink more of it when their incomes are high. This suggests that profits on the project would be highly correlated, but amplified, visa-vis the S&P 500. This, in turn, suggests that the project's beta would be high, and hence that it should be evaluated with a relatively high cost of capital.

d.

Question 7

Since the project is judged to have above-average risk, its differential risk-adjusted, or project, WACC would be 13 percent. At this discount rate, its NPV = $373,272, and it is acceptable. If it were a low risk project, its cost of capital would be 7 percent, its NPV would be $782,468, and it would be an even more profitable project on a differential risk-adjusted basis.

Question 8

a. The project's equity market risk, or beta, is estimated to be 2.0, which indicates that equity invested in this project would be more risky than the average stock. The SML can be used to estimate the project's required rate of return on equity: ksp = kRF + (kM - kRF)bp = 8% + (6%)2 = 8% + 12% = 20%. Still, the project will be financed by 50 percent debt and 50 percent equity, so the project's overall cost of capital is 13 percent: WACCp = kap = wdkd(1 - T) + wsksp = 0.5(10%)(0.6) + 0.5(20%)

=================================================================== ============== OPTIONAL: Note that 13.0 percent is a risk-adjusted cost of capital--it incorporates the project's market risk as measured by its stand-alone beta rather than the firm's overall risk as measured by Robert Montoya's beta. Also note that the project's 13 percent cost of capital is higher than Robert Montoya's overall cost of capital of 10 percent. Thus, the project has considerably more market risk than the firm's average project. In fact, Robert Montoya's overall beta is 1.0, which can be found by performing the following calculations: WACC = wdkd(1 - T) + wsks = 10.0% 0.5(10%)(0.6) + 0.5ks = 10.0% 0.5ks = 7.0% ks = 14.0% = kRF + (kM - kRF)b 14.0% = 8% + (6%)b 6% = (6%)b b = 1.0. =================================================================== ============== b. The two principal methods for estimating a project's beta are (1) the pure play method, and (2) the accounting beta method. In the pure play method, one or more companies which are publicly traded and which are engaged primarily in the same line of business as the project being evaluated are identified. The betas of these companies are then used as a proxy for the project's beta. In the accounting beta method, normal characteristic line regressions are run, but using accounting variables such as EBIT/Total assets in place of market-determined returns. Such accounting betas are then used as proxies for the project's market-determined beta. Since the light wine project represents a new product line, and since there are probably no other companies that produce only light wine, it would be very difficult to estimate the project's beta by either method--the estimate must be judgmental. The advantage of focusing on a project's market risk is that

c.

this is the most relevant risk for stockholders, and hence for value maximization. The disadvantage is that it is impossible to estimate betas for most new projects because it is impossible to find pure play firms and no accounting data exists on them.

Question 9

a. If Plans W and C have average risk, then the appropriate discount rate is the firm's weighted-average cost of capital, 10.0 percent. Then, with a financial calculator, we find these values: PV CostsW = $1,743,426, and PV CostsC = $1,746,056. Since the labor intensive system has the lower PV of costs, it should be chosen. b. If Plan W is riskier than average, a risk adjustment must be made. To begin, consider the impact of a "normal" risk adjustment. Here we would add 3 percentage points to Robert Montoya's cost of capital to produce a project cost of capital of 13 percent. Using this rate, PV CostsW = $1,680,576. Now Plan W looks even better than before. But, if it is riskier, we want to reduce its relative attractiveness, not enhance it. To put it another way, if Plan W is riskier than average, then we want our risk adjustment to penalize it. However, the normal risk adjustment procedure makes W look better, not worse. Since projects typically have positive cash inflows which are being discounted, using an increasing discount rate normally produces a lower NPV, which does penalize riskier projects. However, when costs are being discounted, we want the present value to be higher, not lower, and hence we must use a lower discount rate to adjust for higher risk. Thus, the appropriate discount rate is 7 percent, not 13 percent, and now PV CostsW = $1,812,158. With differential risk properly considered, Plan W is seen to

have a higher PV of costs, and thus Plan C should be chosen. c. Note that Plan W has no IRR, and neither does Plan C. The IRR is that discount rate which equates the PVs of inflows and outflows. If there are only outflows, there can be no IRR, and no MIRR either. Similarly, even though the present value of all the cash outflows can be calculated, the term "net present value" implies that the project has both cash outflows and cash inflows, so cash flows that are either all inflows or all outflows have only a PV, not an NPV. Our conclusion is that, in general, the terms NPV and IRR mean little in the case of projects that do not produce revenues--in such cases, the term PV of costs is more meaningful, and the proper decision rule is to minimize the PV of future costs. However, if the firm must decide whether or not to incur the minimum set of costs, which are required to keep the operation in business, then it will still be necessary to compare the NPV of the entire operation (the PV of future cash flows) with the calculated PV costs of the clean-up project. Many firms whose operations pollute the air or water face this situation today. Included are steel mills, paper mills, chemical plants, electric power stations, and the like. Often, the correct economic decision is to simply close down the plant and move the operations elsewhere, possibly overseas.

Table 1

$2,400,000

===========

Cash Flows:

Year 0 --------

Year 2 -------$44.10 100,000 -------$4,410,000 3,329,280 1,080,000 20,000 -------($19,280) (7,712) -------($11,568) 1,080,000 -------$1,068,432 --------

Year 3 -------$46.31 100,000 -------$4,630,500 3,395,866 360,000 20,000 -------$854,634 341,854 -------$512,781 360,000 -------$872,781 --------

Year 4 -------$48.62 100,000 -------$4,862,025 3,463,783 168,000 20,000 -------$1,210,242 484,097 -------$726,145 168,000 -------$894,145 -------$150,000 60,000 100,000 --------

$40.00

$866,400 --------

Termination CF -------Project NCF ($2,500,000) ======== -------$866,400 ======== -------$1,068,432 ======== -------$872,781 ========

Decision Measures: NPV IRR TV MIRR Payback $566,857 19.8% 4490185 15.8% 2.6

Variable Change from Base Level ___________ -30% -20 -10 0 +10 +20 +30 NPV after Indicated Change: Quantity ___________ ($85,946) 131,655 349,256 566,857 784,458 $1,002,059 $1,219,660 Salvage Value _____________ $548,415 554,563 560,710 566,857 573,004 579,151 585,298 k ________ $782,468 707,951 636,123 566,857 500,034 435,541 373,272

Scenario -------Worst Base Best Prob. ----25% 50% 25% NPV --------($85,946) $566,857 $1,219,660 IRR ----8.4% 19.8% 30.2% MIRR ----9.0% 15.8% 21.5%

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