530Mod7a

Session 11 - Capital Budgeting Cash Flows and Project Risk Analysis, Chapter 11

All page numbers are references to Corporate Finance: A Focused Approach 7th edition by Ehrhardt and Brigham (Cengage Learning, 2020)

Things to Absorb

The most important material is to be able to identify Relevant Cash Flows, for both new and replacement Capital Budgeting projects. This includes calculating initial, operating, and terminal project cash flows. This includes how to handle sunk costs, opportunity costs, depreciation, and cannibalization. Know the basics of how to adjust for inflation (i.e. use real discount rates with real cash flows and nominal (inflation-adjusted) discount rates with nominal cash flows). Know the major terms and brief definitions associated with measuring project risk sensitivity, scenario, break-even, and Monte Carlo simulation. Be able to compute break-evens. Understand the basics of computing risk adjusted Cost of Capital. Be able to define and recognize the major real options. Be able to compute NPV using staged decision trees (will be quizzed, may not be on exams due to time needed to solve each problem). When given information on real options, be able to identify the type of option, who is long, who is short, the underlying asset, the exercise price, and sometimes the premium.

Things You Do Not Need to Absorb

You will not need to compute sensitivity, scenario, or Monte Carlo simulations on an exam.

Things to Read

Read the Chapter.  Here are two versions of a very useful handout on determining Capital Budget Cash Flows, Version 1 and Version 2.  There are full solutions to three problems between the two handouts.  Here is a handout on recognizing Real Options.

Things to Do

Make 100 on the quiz. Be able to solve End of Chapter Questions 1-7 and 9-11, Problems 1-15 and 17. The calculations in this chapter take a lot of time, so I do not expect you to solve all of the previously listed problems. However, you should review each of the problems to determine if you could solve the problem. I consider the following problems to be exam level, 1-10, 12-14, and 17.  If using Excel, you have the Chapter Toolkit with spreadsheet templates to speed your learning.

Calculator links: Most Calculator Types

  1. Watch the Chapter Introduction and Overview video. The PowerPoints for all of this chapter's videos are located here.
  2. Read pages 451-463.
  3. Watch the Relevant Cash Flows, Computing Initial Cash Flows and Computing Depreciation (covers Minicase, pages 493-494, parts a and b) video. After this video, you should be able to answer end of chapter questions 2-5.
  4. Watch the Computing Operating Cash Flows and Terminal Cash Flows and Valuing the Project (covers Minicase parts c-g) video. After this video, you should be able to answer end of chapter problems 1-3 and 5-7.
  5. Read pages 463-473.
  6. Watch the video on Risk in Capital Budgeting, Sensitivity and Scenario Analysis (covers Minicase parts h-l). If you feel you understand the material from the reading, there is no reason to watch this video.
  7. Read the remainder of the chapter.
  8. Watch the video on Simulation Analysis, Risk Adjustments to Cost of Capital, Real Options, with a bonus discussion of Depreciation in the TCJA of 2017 (covers Minicase parts m-n).
  9. My above discussion on real options is pretty good. There is no discussion of decision trees in the minicase, but I do have a problem below that uses a decision tree. Identifying Real Options is a useful skill, if you are interested, watch the video on Spotting Real Options.
  10. Make sure you think you could solve the suggested end of chapter Questions and Problems.
  11. Below are audio solutions related to the estimation of cash flows. Use the following information to answer questions a-e. You have been asked by the president of your company to evaluate the proposed acquisition of new equipment. The equipment's basic price is $177,000, and shipping costs will be $3,500. It will cost another $26,600 to modify it for special use by your firm, and an additional $12,400 to install the equipment. The equipment falls in the MACRS 3-year class, and it will be sold after three years for $22,000. The equipment is expected to generate revenues of $173,000 per year with annual operating costs of $81,000. The firm's tax rate is 30.0%. Here is the MACRS depreciation schedule, Year 1=33%, Year 2=45%, Year 3=15%, Year 4= 7%.
    1. What is the net investment (initial outlay) for the project? | Audio Solution
    2. What is the operating cash flow for year 1? | Audio Solution
    3. What is the operating cash flow for year 2? | Audio Solution
    4. What is the operating cash flow for year 3? | Audio Solution
    5. What is the value of the terminal year non-operating cash flows at the end of Year 3? (What is the after-tax cash flow associated with the sale of the equipment?) | Audio Solution

Use the following information to answer questions f-j. You have been asked by the president of your company to evaluate the proposed acquisition of new equipment. The equipment's basic price is $195,000, and shipping costs will be $3,900. It will cost another $23,400 to modify it for special use by your firm, and an additional $9,800 to install the equipment. The equipment falls in the MACRS 3-year class, and it will be sold after three years for $30,200. The equipment is expected to generate revenues of $179,000 per year with annual operating costs of $90,000. The firm's tax rate is 25.0%. Here is the MACRS depreciation schedule, Year 1=33%, Year 2=45%, Year 3=15%, Year 4= 7%.

    1. What is the net investment (initial outlay) for the project? | Audio Solution
    2. What is the operating cash flow for year 1? | Audio Solution
    3. What is the operating cash flow for year 2? | Audio Solution
    4. What is the operating cash flow for year 3? | Audio Solution
    5. What is the value of the terminal year non-operating cash flows at the end of Year 3? (What is the after-tax cash flow associated with the sale of the equipment?) | Audio Solution
    6. The Target Copy Company is contemplating the replacement of its old printing machine with a new model costing $55,000. The old machine, which originally cost $33,000, has 4 years of expected life remaining and a current book value of $29,000 versus a current market value of $17,000. Target's corporate tax rate is 32 percent. Both machines are in the 7-year MACRS class. The new machine will allows annual sales to increase $10,000 to $14,000, and will will increase the inventory level from $6,000 to $8,000. If Target sells the old machine at market value, what is the initial after-tax outlay for the new printing machine? Since this is a cash outlay, be sure to use the - sign when writing your answer. Do not use the $ symbol or , in your answer. Show your answer to the nearest dollar. | Audio Solution
    7. Your company plans to produce a product for two more years and then to shut down production. You are considering replacing an old machine used in production with a new machine. The Old machine originally cost $818 and was bought Three (3) years ago (i.e. it has depreciated for three years). It could be sold today for $367 or sold in two years for $121. The New machine would cost $703 and could be sold in two years for $231. The new machine is more efficient than the old machine and would reduce waste, and therefore the cost of materials, by $300 per year. Due to the lower waste, we could also have a one-time reduction in inventory of 21. The firm's tax rate is 43%. Both machines are in the 4 year MACRS class, with depreciation amounts of 15%, 45%, 33% and 7%. What are the Operating Cash Flows in the first year (Year 1) with the new machine? | Audio Solution
    8. The Target Copy Company is contemplating the replacement of its old printing machine with a new model costing $ 819. The new machine will operate for 3 years and then project will be shut down and all equipment sold. The old machine, which originally cost $ 601, has 2 years of depreciation remaining and a current book value of 22% of the original cost. The old machine has a current market value of $ 281 and should be worth $ 215 at the end of 3 years. The new printing machine could be sold for $ 269 in 3 years. If we buy the new machine our inventory levels will go from $600 to $900. Inventory levels will return to normal at the end of the project. Our annual sales will go from $15,000 to $20,000. Target's corporate tax rate is 25 percent. Both machines are in the 3-year MACRS class, with rates of 33% for year 1, 45% for year 2, 15% for year 3, and 7% for year 4. What are the expected Terminal Cash Flows at the end of year 3, if we replace the old printing machine? This could be a cash inflow or a cash outlay. Be sure to use the - sign should this be a cash outflow. Show your answer to the nearest $.01 Do not use the $ symbol in your answer. | Audio Solution
    9. Modern Artifacts can produce keepsakes that will be sold for $80 each. Non-depreciation fixed costs are $1,000 per year and variable costs are $60 per unit. If the project requires an initial investment of $3,000 and is expected to last for 5 years and the firm pays no taxes, what are the accounting break-even levels of sales? The initial investment will be depreciated straight-line over 5 years to a final value of zero, and the discount rate is 10%. | Audio Solution
    10. Modern Artifacts can produce keepsakes that will be sold for $80 each. Non-depreciation fixed costs are $1,000 per year and variable costs are $60 per unit. If the project requires an initial investment of $3,000 and is expected to last for 5 years and the firm pays no taxes, what are the economic break-even levels of sales? The initial investment will be depreciated straight-line over 5 years to a final value of zero, and the discount rate is 10%. | Audio Solution
    11. Hit or Miss Sports is introducing a new product this year. If its see-at-night soccer balls are a hit, the firm expects to be able to sell 50,000 units a year at a price of $60 each. If the new product is a bust, only 30,000 units can be sold at a price of $55. The variable cost of each ball is $30, and fixed costs are zero. The cost of the manufacturing equipment is $6 million, and the project life is estimated at 10 years. The firm will use straight-line depreciation over the 10-year life of the project. The firm's tax rate is 35% and the discount rate is 12%. a. If each outcome is equally likely, what is expected NPV? Will the firm accept the project? b. Suppose now that the firm can abandon the project and sell off the manufacturing equipment for $5.4 million if demand for the balls turns out to be weak. The firm will make the decision to continue or abandon after the first year of sales. Does the option to abandon change the firm's decision to accept the project? | Audio Solution
    12. Hit or Miss Sports is introducing a new product this year. If its see-at-night soccer balls are a hit, the firm expects to be able to sell 50,000 units a year at a price of $60 each. If the new product is a bust, only 30,000 units can be sold at a price of $55. The variable cost of each ball is $30, and fixed costs are zero. The cost of the manufacturing equipment is $6 million, and the project life is estimated at 10 years. The firm will use straight-line depreciation over the 10-year life of the project. The firm's tax rate is 35% and the discount rate is 12%.
      1. If each outcome is equally likely, what is expected NPV? Will the firm accept the project?
      2. Now suppose that Hit or Miss Sports from the previous problem can expand production if the project is successful. By paying its workers overtime, it can increase production by 25,000 units; the variable cost of each ball will be higher, however, equal to $35 per unit. By how much does this option to expand production increase the NPV of the project? | Audio Solution
  1. Review the remaining above suggested questions and problems. Be prepared for a 60-80 minute quiz over Chapter 11.

Revised September 18, 2020

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