base-case value, will occur. There is a 25% probability of worst-case conditions, withthe variables 20% worse than base, and a 50% probability of base-case conditions.

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

adjusted NPV, IRR, and payback.

e. On the basis of information in the problem, would you recommend the project

should be accepted?

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Shrieves Casting Company is considering adding a new line to its product mix, and the

lle capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated

MBA. The production line would be set up in unused space in the 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 equip-

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ment. 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

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 both 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, which is the risk-adjusted cost

of capital for an average project (r), is 10%.

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a. Define “incremental cash flow.” toate

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(1) Should you subtract interest expense or dividends when calculating project cash

flow?

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(2) Suppose the firm spent $100,000 last year to rehabilitate the production line site.

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Should this be included in the analysis? Explain.

(3) Now assume the plant space could be leased out to another firm at $25,000 per

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year. Should this be included in the analysis? If so, how?

(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?

496

Part 4 Projects and Their Valuation

annual depreciation expenses?

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important to include inflation when estimating cash flows?

d. Construct annual incremental operating cash flow statements.

b. Disregard the assumptions in Part a. What is the depreciable basis? What are the

c. Calculate the annual sales revenues and costs (other than depreciation). Why is it

e. Estimate the required net working capital for each year and the cash flow due to

investments in net working capital.

f. Calculate the after-tax salvage cash flow.

undertaken?

g. Calculate the net cash flows for each year. Based on these cash flows and the average

project cost of capital, what are the project’s NPV, IRR, MIRR, PI, payback, and

discounted payback? Do these indicators suggest that the project should be

can risk be quantified; and, when risk is quantified, is the quantification based

h. What does the term “risk” mean in the context of capital budgeting; to what extent

primarily on statistical analysis of historical data or on subjective, judgmental

estimates?

i. (1) What are the three types of risk that are relevant in capital budgeting?

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(2) How is each of these risk types measured, and how do they relate to one

another?

(3) How is each type of risk used in the capital budgeting process?

j. (1) What is sensitivity analysis?

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(2) Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital

for the project. Assume each of these variables can vary from its base-case, or

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expected, value by £10%, -20%, and £30%. Include a sensitivity diagram, and

discuss the results.

(3) What is the primary weakness of sensitivity analysis? What is its primary

usefulness?

k. Assume that Sidney Johnson is confident in 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. Johnson believes there is a 25% chance of poor

acceptance, a 25% chance of excellent acceptance, and a 50% chance of average

acceptance (the base case).

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(1) What is scenario analysis?

(2) What is the worst-case NPV? The best-case NPV?

(3) Use the worst-, base-, and best-case NPVs and probabilities of occurrence to

find the project’s expected NPV, as well as the NPV’s standard deviation and

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coefficient of variation.

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1. Are there problems with scenario analysis? Define simulation analysis, and discuss

its principal advantages and disadvantages.

m. (1) Assume the company’s average project has a coefficient of variation

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low risk? What type of risk is being measured here?

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range of 0.2 to 0.4. Would the new line be classified as high risk, average risk, or

capital to adjust for risk. Should the new line be accepted?

(2) Shrieves typically adds or subtracts 3 percentage points to the overall cost of

decision is made?

n. What is a real option? What are some types of real options?

(3) Are there any subjective risk factors that should be considered before the final

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