4/3/2008

Chapter 13. Ch 13-11 Build a Model

Webmasters.com has developed a powerful new server that would be used for corporations Internet activities. It would cost $10 million at Year 0 to buy the equipment necessary to manufacture the server. The project would require net working capital at the beginning of each year equal to 10% of sales; NOWC 0 = 10%(Sales1), NOWC1 = 10%(Sales2), etc. The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. After Year 1, the sales price and variable costs would increase at the inflation rate of 3%. The companys nonvariable costs would be $1 million at Year 1, and would increase with inflation. The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. Also, the projects returns are expected to be highly correlated with returns on the firms other assets. The firm believes it could sell 1,000 units per year.

The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of the equipment at the end of the projects 4-year life is $500,000. Webmasters federal-plus-state tax rate is 40%. Its cost of capital is 10% for average risk projects, defined as projects with a coefficient of variation for NPV between 0.8 and 1.2. Low risk projects are evaluated with a WACC of 8%, and high risk projects at 13%. a. Develop a spreadsheet model and use it to find the projects NPV, IRR, and payback.

Part 1. Input Data (in thousands of dollars) Equipment cost Net Operating WC/sales First year sales (in units) Sales price per unit Variable cost per unit Non-variable costs $10,000 10% 1,000 $24.00 $17.50 $1,000

Key Output: NPV = IRR = MIRR = Market value of equipment at Year 4 Tax rate WACC Inflation $500 40% 10% 3.0%

Part 2. Depreciation and Amortization Schedule Year Initial Cost Equipment Depr'n Rate Equipment Depr'n, Dollars Ending Bk Val: Cost - Accum Dep'rn Part 3. Net Salvage Values, in Year 4 Estimated Market Value in Year 4 Book Value in Year 4 Expected Gain or Loss Taxes paid or tax credit Net cash flow from salvage

1 20.0%

Years 2 32.0%

3 19.0%

4 12.0%

Accum'd Depr'n

Equipment

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Part 4. Projected Net Cash Flows (Time line of annual cash flows) Years 0 Investment Outlays at Time Zero: Equipment Operating Cash Flows over the Project's Life: Units sold Sales price Variable costs Sales revenue Variable costs Non-variable operating costs Depreciation (equipment) Oper. income before taxes (EBIT) Taxes on operating income (40%) Net Operating Profit After Taxes (NOPAT) Add back depreciation Operating cash flow Terminal Year Cash Flows: Required level of net operating working capital Required investment in NOWC Terminal Year Cash Flows: Net salvage value Net Cash Flow (Time line of cash flows) Part 5. Key Output: Appraisal of the Proposed Project Net Present Value (at 10%) IRR MIRR Payback (See calculation below) Data for Payback Years Net cash flow Cumulative CF Part of year required for payback: 0 1

b. Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and number of units sold. Set these variables values at 10% and 20% above and below their base case values. Include a graph in your analysis.

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Part 6. Evaluating Risk: Sensitivity Analysis I. Sensitivity of NPV to Changes in Inputs. Here we use an Excel "Data Table" to find NPV holding other thing constant. % Deviation 1st YEAR UNIT SALES from Units NPV Base Case Sold -20% -10% 0% 10% 20% % Deviation VARIABLE COSTS from Variable NPV Base Case Costs -20% -10% 0% 10% 20% % DeviationNON-VARIABLE COSTS from Fixed NPV Base Case Costs -20% -10% 0% 10% 20% % Deviation from Base Case -20% -10% 0% 10% 20% % Deviation from Base Case -20% -10% 0% 10% 20% WACC NPV WACC different unit sales,

SALES PRICE Sales NPV Price

Note about data tables. The data in the column input should NOT be input using a cell reference to the column input cell. For example the base case number of units sold in cell B105 should be the number 1000; you should NOT have the formula =D29 in that cell. This is because you'll use D29 as the column input cell in the data table and if Excel tries to iteratively replace cell D29 with the formula =D29 rather than a series of numbers, Excel will calculate the wrong answer. Unfortunately, Excel won't tell you that there is a problem, so you'll just get the wrong values for the data table!

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example the base case number of units sold in cell B105 should be the number 1000; you should NOT have the formula =D29 in that cell. This is because you'll use D29 as the column input cell in the data table and if Excel tries to iteratively replace cell D29 with the formula =D29 rather than a series of numbers, Excel will calculate the wrong answer. Unfortunately, Excel won't tell you that there is a problem, so you'll just get the wrong values for the data table!

Deviation from Base Case -20% -10% 0% 10% 20% Range

Sales Price $0 $0 $0 $0 $0

NPV at Different Deviations from Base Variable Non-variable Cost/Unit Units Sold Cost $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0

WACC $0 $0 $0 $0 $0

c. Now conduct a scenario analysis. Assume that there is a 25% probability that best case conditions, with each of the variables discussed in Part b being 20% better than its base case value, will occur. There is a 25% probability of worst case conditions, with the variables 20% worse than base, and a 50% probability of base case conditions.

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Part 7. Evaluating Risk: Scenario Analysis Sales Price $28.80 $24.00 $19.20 Unit Sales 1,200 1,000 800 Variable Costs $14.00 $17.50 $21.00

Scenario Best Case Base Case Worst Case

Probability 25% 50% 25%

NPV

Squared Deviation Times Probability

Expected NPV = sum, prob times NPV Standard Deviation = Sq Root of column H sum Coefficient of Variation = Std Dev / Expected NPV

d. If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and payback.

Risk adjusted NPV = IRR = Payback = e. Based on the information in the problem, would you recommend that the project be accepted?

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