Solutions to Practice Problems

Module 5
Chapter 12

12-8. NEW PROJECT ANALYSIS You must evaluate the purchase of a proposed spectrometer for
the R&D department. The base price is $140,000, and it would cost another $30,000 to
modify the equipment for special use by the firm. The equipment falls into the MACRS
3-year class and would be sold after 3 years for $60,000. The applicable depreciation rates
are 33%, 45%, 15%, and 7%, as discussed in Appendix 12A. The equipment would require
an $8,000 increase in net operating working capital (spare parts inventory). The project
would have no effect on revenues, but it should save the firm $50,000 per year in before-tax
labor costs. The firm’s marginal federal-plus-state tax rate is 40%.
a. What is the initial investment outlay for the spectrometer, that is, what is the Year 0
project cash flow?
b. What are the project’s annual cash flows in Years 1, 2, and 3?
c. If the WACC is 12%, should the spectrometer be purchased? Explain.

12-8 a. CF0 = -$178,000:

Initial investment outlay at t = 0:
Price ($140,000)
Modification (30,000)
CAPEX ($170,000)
NOWC (8,000)
Initial investment outlay ($178,000)

b. Project’s operating cash flows:

Year 1 Year 2 Year 3  
Savings $50,000 $50,000 $50,000
Depreciation 56,100 76,500 25,500
EBIT ($ 6,100) ($26,500) $24,500
Taxes (35%) (2,135) (9,275) 8,575
EBIT(1 – T) ($ 3,965) ($17,225) $15,925
Add Depreciation 56,100 76,500 25,500
EBIT(1 –T) + DEP $52,135 $59,275 $41,425

Terminal cash flows at t = 3:

Salvage value $60,000
Tax on salvage value 16,835
AT salvage value $43,165
NOWC = Recovery of NOWC 8,000
Project FCFs = EBIT(1 – T)
+ DEP – CAPEX – NOWC $52,135 $59,275 $92,590

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 Notes:
1. The depreciation expense in each year is the depreciable basis, $170,000, times the MACRS
allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3, respectively. Depreciation expense
in Years 1, 2, and 3 is $56,100, $76,500, and $25,500.

2. Remaining BV in Year 4 = $170,000(0.07) = $11,900.

Tax on SV = ($60,000 – $11,900)(0.35) = $16,835.

c. The project has an NPV of ($8,783). Thus, it should not be accepted.

Year Cash Flows PV @ 9%

0 ($178,000) ($178,000)
1 52,135 47,830
2 59,275 49,891
3 92,590 71,496
NPV = ($ 8,783)

2
 Alternatively, place the free cash flows on a time line:
0 1 2 3
9%
| | | |
Initial investment outlay -178,000
EBIT(1 – T) + DEP 52,135 59,275 41,425
Terminal cash flows 51,165
Project FCFs -178,000 52,135 59,275 92,590

With a financial calculator, input the cash flows into the cash flow register, I/YR = 9, and then
solve for NPV = -$8,782.67  -$8,783.

12-9. NEW PROJECT ANALYSIS You must evaluate a proposal to buy a new milling machine.
The base price is $108,000, and shipping and installation costs would add another $12,500.
The machine falls into the MACRS 3-year class, and it would be sold after 3 years for
$65,000. The applicable depreciation rates are 33%, 45%, 15%, and 7% as discussed in
Appendix 12A. The machine would require a $5,500 increase in net operating working
capital (increased inventory less increased accounts payable). There would be no effect
on revenues, but pretax labor costs would decline by $44,000 per year. The marginal tax
rate is 35%, and the WACC is 12%. Also, the firm spent $5,000 last year investigating the
feasibility of using the machine.
a. How should the $5,000 spent last year be handled?
b. What is the initial investment outlay for the machine for capital budgeting purposes,
that is, what is the Year 0 project cash flow?
c. What are the project’s annual cash flows during Years 1, 2, and 3?
d. Should the machine be purchased? Explain your answer.

12-9 a. The $4,500 spent last year on exploring the feasibility of the project is a sunk cost and should
not be included in the analysis.

b. The initial investment outlay at t = 0 is $148,000:

Price ($135,000)
Modification (8,000)
CAPEX ($143,000)
NOWC (5,000)
Initial investment outlay ($148,000)

CF0 = -$148,000.

c. The annual project cash flows follow:

Project’s operating cash flows:
Year 1 Year 2 Year 3  
Savings $52,000 $52,000 $ 52,000
Depreciation 47,190 64,350 21,450
EBIT $ 4,810 ($12,350) $ 30,550
Taxes (35%) 1,684 (4,323) 10,693
EBIT(1 – T) $ 3,127 ($ 8,028) $ 19,858
Add Depreciation 47,190 64,350 21,450
EBIT(1 –T) + DEP $50,317 $56,323 $ 41,308

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 Terminal cash flows at time = 3:
Salvage value $ 94,500
Tax on salvage value 29,572
AT salvage value $ 64,928
NOWC = Recovery of NOWC 5,000
Project FCFs = EBIT(1 – T)
+ DEP – CAPEX – NOWC $50,317 $56,323 $111,236

Notes:
1. The depreciation expense in each year is the depreciable basis, $143,000, times the MACRS
allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3, respectively. Depreciation
expense in Years 1, 2, and 3 is $47,190, $64,350, and $21,450.

2. BV in Year 4 = $143,000(0.07) = $10,010.

Tax on SV = ($94,500 – $10,010)(0.35) = $29,572.

d. The project has an NPV of $35,180; thus, it should be accepted.

Year Cash Flows PV @ 8%

0 ($148,000) ($148,000)
1 50,317 46,590
2 56,323 48,288
3 111,236 88,302
NPV = $ 35,180

Alternatively, place the free cash flows on a time line:

0 1 2 3
8%
| | | |
Initial investment outlay -148,000
EBIT(1 – T) + DEP 50,317 56,323 41,308
Terminal cash flows _______ ______ ______ 69,928
Project FCFs -148,000 50,317 56,323 111,236

With a financial calculator, input the appropriate cash flows into the cash flow register, input
I/YR = 8, and then solve for NPV = $35,180.43  $35,180.

12-13. UNEQUAL LIVES Haley’s Graphic Designs Inc. is considering two mutually exclusive
projects. Both projects require an initial investment of $10,000 and are typical average-risk
projects for the firm. Project A has an expected life of 2 years with after-tax cash inflows of
$6,000 and $8,000 at the end of Years 1 and 2, respectively. Project B has an expected life of
4 years with after-tax cash inflows of $4,000 at the end of each of the next 4 years. The firm’s
WACC is 10%.
a. If the projects cannot be repeated, which project should be selected if Haley uses NPV
as its criterion for project selection?
b. Assume that the projects can be repeated and that there are no anticipated changes in
the cash flows. Use the replacement chain analysis to determine the NPV of the project
selected.
c. Make the same assumptions as in part b. Using the equivalent annual annuity (EAA)
method, what is the EAA of the project selected?

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12-13 a. Project A: 0 1 2
12%
| | |
-11,000 8,000 10,000

Using a financial calculator, input the following data: CF 0 = -11000, CF1 = 8000, CF2 = 10000,
I/YR = 12, and then solve for NPVA = $4,114.80.

Project B: 0 1 2 3 4
12%
| | | | |
-11,000 5,500 5,500 5,500 5,500

Using a financial calculator, input the following data: CF 0 = -11000, CF1-4 = 5500, I/YR = 12,
and then solve for NPVB = $5,705.42.

Since neither project can be repeated, Project B should be selected because it has a higher
NPV than Project A.

b. To determine the answer to Part b, we use the replacement chain (common life) approach to
calculate the extended NPV for Project A. Project B already extends out to 4 years, so its NPV is
$5,705.42.

Project A: 0 1 2 3 4
12%
| | | | |
-11,000 8,000 10,000
-11,000 8,000 10,000
-1,000

Using a financial calculator, input the following data: CF 0 = -11000, CF1 = 8000, CF2 = -1000,
CF3 = 8000, CF4 = 10000, I/YR = 12, and then solve for NPVA = $7,395.09.

Since Project A’s extended NPV = $7,395.09, it should be selected over Project B with an NPV
= $5,705.42.
c. From Part a, NPVA = $4,114.80 and NPVB = $5,705.42. Solving for PMT determines the EAA:
Project A: N = 2, I/YR = 12, PV = -4114.80, FV = 0; solve for PMT = EAAA = $2,434.72.

Project B: N = 4, I/YR = 12, PV = -5705.42, FV = 0; solve for PMT = EAAB = $1,878.42.

Project A should be selected.

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12-16. REPLACEMENT CHAIN The Fernandez Company has an opportunity to invest in one of
two mutually exclusive machines that will produce a product the company will need for
the next eight years. Machine A costs $10 million but will provide after-tax inflows of
$4 million per year for 4 years. If Machine A were replaced, its cost would be $12 million
due to inflation and its cash inflows would increase to $4.2 million due to production
efficiencies. Machine B costs $15 million and will provide after-tax inflows of $3.5 million
per year for 8 years. If the WACC is 10%, which machine should be acquired? Explain.

12-16 A: 0 1 2 3 4 5 6 7 8
9%
| | | | | | | | |

-8.9 4.5 4.5 4.5 4.5

-9.8 4.7 4.7 4.7 4.7

-5.3

Since Machine A’s renewal investment and cash flows change the EAA method cannot be used, so
the replacement chain method must be used. Machine A’s simple NPV is calculated as follows:
Enter CF0 = -8.9 and CF1-4 = 4.5. Then enter I/YR = 9 and press the NPV key to get NPV A =
$5.679 million. However, this does not consider the fact that the project can be repeated. Enter
these values into the cash flow register: CF 0 = -8.9; CF1-3 = 4.5; CF4 = -5.3; CF5-8 = 4.7. Then
enter I/YR = 9 and press the NPV key to get extended NPVA = $9.523 million.

B: 0 9%
1 2 3 4 5 6 7 8
| | | | | | | | |

-13.9 4.3 4.3 4.3 4.3 4.3 4.3 4.3 4.3

Enter these cash flows into the cash flow register, along with the interest rate, and press the NPV
key to get NPVB = $9.900 million.

Machine B is the better project and will increase the company's value by $9.900 million, rather than
the $9.523 million created by Machine A.

12-18. SCENARIO ANALYSIS Your firm, Agrico Products, is considering a tractor that would have
a cost of $36,000, would increase pretax operating cash flows before taking account of
depreciation by $12,000 per year, and would be depreciated on a straight-line basis to zero
over 5 years at the rate of $7,200 per year beginning the first year. (Thus, annual cash flows
would be $12,000 before taxes plus the tax savings that result from $7,200 of depreciation.)
The managers disagree about whether the tractor would last 5 years. The controller insists
that she knows of tractors that have lasted only 4 years. The treasurer agrees with the

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controller, but he argues that most tractors do give 5 years of service. The service manager
then states that some last for as long as 8 years.
Given this discussion, the CFO asks you to prepare a scenario analysis to determine the
importance of the tractor’s life on the NPV. Use a 40% marginal federal-plus-state tax rate, a
zero salvage value, and a 10% WACC. Assuming each of the indicated lives has the same
probability of occurring probability = 1 / 3 , what is the tractor’s expected NPV? (Hint: Use
the 5-year straight-line depreciation for all analyses, and ignore the MACRS half-year
convention for this problem.)

12-18 If actual life is 5 years:

Using a time line approach:
0 1 2 3 4 5
10%
| | | | | |
Investment outlay (36,000)
Operating cash flows
excl. deprec. (AT) 7,200 7,200 7,200 7,200 7,200
Depreciation savings 2,880 2,880 2,880 2,880 2,880
Project cash flows (36,000) 10,080 10,080 10,080 10,080 10,080

NPV5 = $2,211.13.

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 If actual life is 4 years:
Using a time line approach:
0 1 2 3 4
10%
| | | | |
Investment outlay (36,000)
Operating cash flows
excl. deprec. (AT) 7,200 7,200 7,200 7,200
Depreciation savings 2,880 2,880 2,880 2,880
Tax savings on loss 2,880
Project cash flows (36,000) 10,080 10,080 10,080 12,960

NPV4 = -$2,080.68.

If actual life is 8 years:

Using a time line approach:
0 1 5 6 7 8
10%
| |   | | | |
Investment outlay (36,000)
Operating cash flows
excl. deprec. (AT) 7,200 7,200 7,200 7,200 7,200
Depreciation savings 2,880 2,880
Project cash flows (36,000) 10,080 10,080 7,200 7,200 7,200

NPV8 = $13,328.93.

If the life is as low as 4 years (an unlikely event), the investment will not be desirable. But, if the
investment life is longer than 4 years, the investment will be a good one. Therefore, the decision
will depend on the managers' confidence in the life of the tractor. If each of the indicated lives has
the same probability of occurring E(NPV) = $4,486.46.

12-22 NEW PROJECT ANALYSIS You must analyze a potential new product—a caulking compound
that Cory Materials’ R&D people developed for use in the residential construction
industry. Cory’s marketing manager thinks the company can sell 115,000 tubes per year at a
price of $3 25 each for 3 years, after which the product will be obsolete. The required
equipment would cost $150,000, plus another $25,000 for shipping and installation. Current
assets (receivables and inventories) would increase by $35,000, while current liabilities
(accounts payable and accruals) would rise by $15,000. Variable cost per unit is $1 95, fixed
costs (exclusive of depreciation) would be $70,000 per year, and fixed assets would be
depreciated under MACRS with a 3-year life. (Refer to Appendix 12A for MACRS depreciation
rates.) When production ceases after 3 years, the equipment should have a market
value of $15,000. Cory’s tax rate is 40%, and it uses a 10% WACC for average-risk projects.
a. Find the required Year 0 investment and the project’s annual cash flows. Then calculate
the project’s NPV, IRR, MIRR, and payback. Assume at this point that the project is of
average risk.
b. Suppose you now learn that R&D costs for the new product were $30,000 and that those
costs were incurred and expensed for tax purposes last year. How would this affect
your estimate of NPV and the other profitability measures?
c. If the new project would reduce cash flows from Cory’s other projects and if the new

8
project would be housed in an empty building that Cory owns and could sell, how would
those factors affect the project’s NPV?
d. Are this project’s cash flows likely to be positively or negatively correlated with returns
on Cory’s other projects and with the economy, and should this matter in your analysis?
Explain.
e. Unrelated to the new product, Cory is analyzing two mutually exclusive machines that
will upgrade its manufacturing plant. These machines are considered average-risk
projects, so management will evaluate them at the firm’s 10% WACC. Machine X has a
life of 4 years, while Machine Y has a life of 2 years. The cost of each machine is $60,000;
however, Machine X provides after-tax cash flows of $25,000 per year for 4 years and
Machine Y provides after-tax cash flows of $42,000 per year for 2 years. The manufacturing
plant is very successful, so the machines will be repurchased at the end of each
machine’s useful life. In other words, the machines are “repeatable” projects.
1. Using the replacement chain method, what is the NPV of the better machine?
2. Using the EAA method, what is the EAA of the better machine?
f. Spreadsheet assignment: at instructor’s option Construct a spreadsheet that calculates
the cash flows, NPV, IRR, payback, and MIRR.
g. The CEO expressed concern that some of the base-case inputs for the caulking compound
might be too optimistic or too pessimistic, and he wants to know how the NPV
would be affected if these six variables were 20% above or 20% below the base-case
levels: unit sales, sales price, variable cost, fixed costs, WACC, and equipment cost.
Hold other things constant when you consider each variable and construct a sensitivity
graph to illustrate your results.
h. Do a scenario analysis based on the assumption that there is a 25% probability that each
of the six variables itemized in part g will turn out to have their best-case values as
calculated in part g, a 50% probability that all will have their base-case values, and a
25% probability that all will have their worst-case values. The other variables remain at
base-case levels. Calculate the expected NPV, the standard deviation of NPV, and the
coefficient of variation.
i. Does Cory’s management use the risk-adjusted discount rate to adjust for project risk?
Explain.

12-22 a. NPV (at 10% ) $4,014

IRR 11.11%
MIRR 10.75%
Applies MIN function to Row 80 to find first year when payback
Payback (see calculation below) 2.49 is positive.

Data for Payback Years 0 1 2 3

Cumulative CF from Row 68 (195,000) (124,200) (45,000) 47,100
IF Function to find payback FALSE FALSE 2.49

b. The $30,000 R&D costs are sunk costs. Therefore, these costs will have no effect on NPV and
other profitability measures.

c. If the new project will reduce cash flows from the firm's other projects, then this is a negative
externality and must be considered in the analysis. Consequently, these should be considered
costs of the new project and would reduce the project's NPV. If the project can be housed in
an empty building that the firm owns and could sell if it was not used for the project, then this
is an opportunity cost which should also be considered as a "cost" of this project. The after-tax
sales amount for this building will reduce the project's NPV.

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d. The project's cash flows are likely to be positively correlated with returns on the firm's other
projects and with the economy. The firm is involved with building materials, and caulking
compound is a building material, so it is a similar product to the firm's other products. In
addition, when the economy is booming, housing starts increase—which would mean an
increase in sales of the caulking compound. Whether a project is positively or negatively
correlated with the firm's other projects impacts the risk of the project and the relevant cost of
capital at which it should be evaluated.

e. 1.
WACC: 10.0%
Machine X:
0 1 2 3 4
(60,000) 25,000 25,000 25,000 25,000

NPV 19,247

WACC: 10.0%
Machine Y:
0 1 2 3 4
(60,000) 42,000 42,000
(60,000) 42,000 42,000
(60,000) 42,000 (18,000) 42,000 42,000

2-yr NPV 12,893

Extended NPV 23,548

e. 2.
Machine X:
N 4
I/YR 10.00%
PV (19,247)
FV 0
PMT = EAA 6,072

Machine Y:
N 2
I/YR 10.00%
PV (12,893)
FV 0
PMT = EAA 7,429
Notice that both the replacement chain and EAA methods give the same project acceptance. Also, remember that the EAA
uses the NPV of the original life of the project for Machine Y. Machine Y should be accepted because it has the higher
NPV and the higher EAA.

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f. Key Output: NPV = $4,014
IRR = 11.11%
Part 1. Key Input Data MIRR = 10.75%

Equipment cost plus installation $175,000 Equip. market value at end of 3 yrs $15,000
Increase in current assets $35,000 Tax rate 40%
Increase in payables and accruals $15,000 WACC 10%
Unit sales 115,000
Sales price per unit $3.25
Variable cost per unit (in dollars) $1.95
Fixed costs $70,000

Part 2. Depreciation and Amortization Schedule Years Accum'd

Year Initial Cost 1 2 3 Deprn
175,000
Equipment Deprn Rate 33.0% 45.0% 15.0%
Equipment Deprn, Dollars $57,750 $78,750 $26,250 $162,750
Ending Bk Val: Cost – Accum'd Deprn $12,250

Part 3. Net Salvage Values, at End of Year 3 Equipment

Estimated Market Value at End of Year 3 $15,000
Book Value at End of Year 3 12,250
Expected Gain or Loss 2,750
Taxes paid or tax credit 1,100
Net cash flow from salvage $13,900

Part 4. Project Cash Flows (Time Line of Annual Cash Flows)

0 1 2 3
Investment Outlays at Time = 0:
Equipment (175,000)
Increase in NOWC (20,000)

Operating Cash Flows over the Project's Life:

Units sold 115,000 115,000 115,000
Sales price $3.25 $3.25 $3.25

Sales revenue $373,750 $373,750 $373,750

Variable costs 224,250 224,250 224,250
Fixed operating costs 70,000 70,000 70,000
Depreciation 57,750 78,750 26,250
EBIT $21,750 $750 $53,250
Taxes (40% ) 8,700 300 21,300
EBIT(1 – T) $13,050 $450 $31,950
Add back depreciation 57,750 78,750 26,250
EBIT (1 – T) + DEP $70,800 $79,200 $58,200
Terminal Cash Flows at Time = 3
Salvage value $15,000
Tax on salvage value 1,100
After-tax salvage value $13,900
Recovery of NOWC 20,000

Project FCF: EBIT(1 – T) + DEP – CAPEX – ΔNOWC ($195,000) $70,800 $79,200 $92,100

Part 5. Key Output: Appraisal of the Proposed Project

NPV (at 10% ) $4,014

IRR 11.11%
MIRR 10.75%
Applies MIN function to Row 80 to find first year when payback
Payback (see calculation below) 2.49 is positive.

Data for Payback Years 11 0 1 2 3

Cumulative CF from Row 68 (195,000) (124,200) (45,000) 47,100
IF Function to find payback FALSE FALSE 2.49
 Salvage value $15,000
Tax on salvage value 1,100
After-tax salvage value $13,900
Recovery of NOWC 20,000

Part 5. Key Output: Appraisal of the Proposed Project

NPV (at 10% ) $4,014

IRR 11.11%
MIRR 10.75%
Applies MIN function to Row 80 to find first year when payback
Payback (see calculation below) 2.49 is positive.

Data for Payback Years 0 1 2 3

Cumulative CF from Row 68 (195,000) (124,200) (45,000) 47,100
IF Function to find payback FALSE FALSE 2.49

g. Sensitivity of NPV to Changes in Inputs. Here we use an Excel "Data Table" to find NPV
if each variable were better or worse than the base-case level, holding other things constant.

% Deviation UNIT SALES % Deviation WACC

from Units NPV from NPV
Base Case Sales $4,014 Base Case WACC 4,014
-20% 92,000 -$40,600 -20% 8.0% $11,569
-10% 103,500 -$18,293 -10% 9.0% $7,733
0% 115,000 $4,014 Base Case 0% 10.0% $4,014
10% 126,500 $26,321 10% 11.0% $407
20% 138,000 $48,628 20% 12.0% -$3,093

% Deviation VARIABLE COSTS % Deviation SALES PRICE

from Variable NPV from Sales NPV
Base Case Costs $4,014 Base Case Price $4,014
-20% $1.56 $70,935 -20% $2.60 -$107,521
-10% $1.76 $37,475 -10% $2.93 -$51,753
0% $1.95 $4,014 Base Case 0% $3.25 $4,014
10% $2.15 -$29,446 10% $3.58 $59,782
20% $2.34 -$62,907 20% $3.90 $115,550

% Deviation FIXED COSTS % Deviation EQUIPMENT COST

from Fixed NPV from Equipment NPV
Base Case Costs $4,014 Base Case Cost $4,014
-20% $56,000 $24,904 -20% $140,000 $27,294
-10% $63,000 $14,459 -10% $157,500 $15,654
0% $70,000 $4,014 Base Case 0% $175,000 $4,014
10% $77,000 -$6,431 10% $192,500 -$7,625
20% $84,000 -$16,875 20% $210,000 -$19,265

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 Sensitivity Analysis
NPV

$70,000

Sales Price
$50,000

$30,000 Unit Sales

$10,000 WACC

($10,000) FC

Equipment Cost
($30,000) VC

($50,000)
-20% -10% 0% 10% 20%

Deviation NPV at Different Deviations from Base

from Sales Variable Unit Fixed Equipment
Base Case Price Costs Sales Costs WACC Cost
-20% ($107,521) $70,935 ($40,600) $24,904 $11,569 $27,294
-10% ($51,753) $37,475 ($18,293) $14,459 $7,733 $15,654
0% $4,014 $4,014 $4,014 $4,014 $4,014 $4,014
10% $59,782 ($29,446) $26,321 ($6,431) $407 ($7,625)
20% $115,550 ($62,907) $48,628 ($16,875) ($3,093) ($19,265)

Range 223,071 133,842 89,228 41,779 14,662 46,559

h. Note that "best-case" values for variable costs, fixed costs, WACC, and equipment cost are
20% less than base-case values, while the "worst-case" values for variable costs, fixed costs,
WACC, and equipment cost are 20% higher than base-case values.

Squared
Deviation
Sales Variable Unit Fixed Equipment Times
Scenario Probability Price Costs Sales Costs WACC Cost NPV Probability

Best Case 25% $3.90 $1.56 138,000 $56,000 8% $140,000 $324,244 22223605763
Base Case 50% $3.25 $1.95 115,000 $70,000 10% $175,000 $4,014 243729670
Worst Case 25% $2.60 $2.34 92,000 $84,000 12% $210,000 ($227,902) 16128328834
38595664267
Expected NPV = sum, prob times NPV $26,093
Standard Deviation = Sq Root of column J sum $196,458
Coefficient of Variation = Std Dev / Expected NPV 7.53
a. Probability Graph
Probability

50%

25%

(227,902) 0 26,093 324,244

NPV ($)
Most Likely Mean of distribution

b. Continuous Approximation 13

Probability Density
 Probability Graph
Probability

50%

25%

(227,902) 0 26,093 324,244

4,014 NPV ($)
Most Likely Mean of distribution

Continuous Approximation

Probability Density

(227,902) 0 26,093 324,244

NPV ($)
4,014

The scenario analysis suggests that the project could be highly profitable, but also that it is
quite risky. There is a 25% probability that the project would result in a loss of $227,902.
There is also a 25% probability that it could produce an NPV of $324,244. The standard
deviation is high, at $196,458, and the coefficient of variation is high, 7.53.

i. A risk-adjusted discount rate is the cost of capital appropriate for a given project, given the
riskiness of that project. The greater its risk, the higher the project’s cost of capital. If Cory
used a risk-adjusted discount rate, this project’s cost of capital would be increased above the
firm’s 10% WACC to reflect its greater risk as determined from the project’s CV of 7.53. If Cory
increased the WACC used to analyze this project’s NPV by 2 percentage points, then this
project would not be accepted as its NPV at a 12% WACC would be -$3,093.

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 Chapter 13

13-1
GROWTH OPTION Martin Development Co. is deciding whether to proceed with Project X.
The cost would be $9 million in Year 0. There is a 50% chance that X would be hugely
successful and would generate annual after-tax cash flows of $6 million per year during
Years 1, 2, and 3. However, there is a 50% chance that X would be less successful and
would generate only $1 million per year for the 3 years. If Project X is hugely successful, it
would open the door to another investment, Project Y, which would require an outlay of
$10 million at the end of Year 2. Project Y would then be sold to another company at a price
of $20 million at the end of Year 3. Martin’s WACC is 11%.
a. If the company does not consider real options, what is Project X’s expected NPV?
b. What is X’s expected NPV with the growth option?
c. What is the value of the growth option?

13-1 a. WACC = 9%; cash flows shown in millions.

0 1 2 3 NPV @ Yr. 0
50% Prob. | | |
7 7 7 $6.7191
-11
| | | -8.4687
50% Prob. 1 1 1

Expected NPV = 0.5($6.7191) + 0.5(-$8.4687) = -$0.8748 million. The project would not be
done.

b. If the project is hugely successful, $8 million will be spent at the end of Year 2, and the new
venture will be sold for $16 million at the end of Year 3.

0 1 2 3 NPV @ Yr. 0
50% Prob. | | |
7 7 7
-8 +16 $12.3406
-11 -1 23
| | | -8.4687
50% Prob. 1 1 1

Expected NPV = 0.5($12.3406) + 0.5(-$8.4687) = $1.936 million.

c. Value of growth option:

NPV with option $1.936 million
NPV without option - 0.000
+$1.936 million

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13-3. INVESTMENT TIMING OPTION Digital Inc. is considering the production of a new cell
phone. The project will require an investment of $15 million. If the phone is well
received, the project will produce cash flows of $10 million a year for 3 years; but if
the market does not like the product, the cash flows will be only $2 million per year.
There is a 50% probability of both good and bad market conditions. Digital can
delay the project a year while it conducts a test to determine whether demand will
be strong or weak. The delay will not affect the dollar amounts involved for the
project’s investment or its cash flows—only their timing. Because of the anticipated
shifts in technology, the 1-year delay means that cash flows will continue only 2 years
after the initial investment is made. Digital’s WACC is 10%. What action do you
recommend?

13-3 Cash flows shown in millions on time line:

0 8% 1 2 3

-13 5 5 5

NPV = -$0.1145 million.

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 Wait 1 year; cash flows shown in millions on time line:
0 8% 1 2 3 NPV @ Yr. 0
Strong demand | | | |
50% Prob. 0 -13 8 8 $1.1723

Weak demand | | | |
50% Prob. 0 -13 2 2-$8.7347

However, if demand is weak, the project’s NPV is negative and therefore would not be undertaken.
The value of this option of waiting one year is evaluated as 0.5($0) + (0.5)($1.1723) = $0.5862
million. Since the NPV of waiting one year is positive and greater than going ahead and proceeding
with the project today, it makes sense to wait.

13-4. ABANDONMENT OPTION The Scampini Supplies Company recently purchased a new
delivery truck. The new truck costs $22,500, and it is expected to generate after-tax cash
flows, including depreciation, of $6,250 per year. The truck has a 5-year expected life. The
expected year-end abandonment values (salvage values after tax adjustments) for the truck
are given here. The company’s WACC is 10%.
Year Annual After-Tax Cash Flow Abandonment Value
0 ($22,500) –
1 6,250 $17,500
2 6,250 14,000
3 6,250 11,000
4 6,250 5,000
5 6,250 0
a. Should the firm operate the truck until the end of its 5-year physical life; if not, what is
the truck’s optimal economic life?
b. Would the introduction of abandonment values, in addition to operating cash flows,
ever reduce the expected NPV and/or IRR of a project? Explain.

13-4 a. NPV of abandonment after Year t:

Using a financial calculator, input the following: CF0 = -22500, CF1 = 23750, and I/YR = 10 to
solve for NPV1 = -$909.09  -$909.

Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, CF2 = 20250, and
I/YR = 10 to solve for NPV2 = -$82.64  -$83.

Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, Nj = 2, CF3 =
17250, and I/YR = 10 to solve for NPV3 = $1,307.29  $1,307.

Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, Nj = 3, CF4 =
11250, and I/YR = 10 to solve for NPV4 = $726.73  $727.

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 Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, Nj = 5, and I/YR =
10 to solve for NPV5 = $1,192.42  $1,192.

The firm should operate the truck for 3 years, NPV3 = $1,307.

b. No. Abandonment possibilities could only raise NPV and IRR. The value of the firm is
maximized by abandoning the project after Year 3.

13-5 OPTIMAL CAPITAL BUDGET Hampton Manufacturing estimates that its WACC is 12.5%.
The company is considering the following seven investment projects:
Project Size IRR
A $ 750,000 14.0%
B 1,250,000 13.5
C 1,250,000 13.2
D 1,250,000 13.0
E 750,000 12.7
F 750,000 12.3
G 750,000 12.2
a. Assume that each of these projects is independent and that each is just as risky as the
firm’s existing assets. Which set of projects should be accepted, and what is the firm’s
optimal capital budget?
b. Now assume that Projects C and D are mutually exclusive. Project D has an NPV of
$400,000, whereas Project C has an NPV of $350,000. Which set of projects should
be accepted, and what is the firm’s optimal capital budget?
c. Ignore part b and assume that each of the projects is independent but that management
decides to incorporate project risk differentials. Management judges Projects B, C, D,
and E to have average risk; Project A to have high risk; and Projects F and G to have low
risk. The company adds 2% to the WACC of those projects that are significantly more
risky than average, and it subtracts 2% from the WACC of those projects that are
substantially less risky than average. Which set of projects should be accepted, and
what is the firm’s optimal capital budget?

13-5 a. WACC = 12.5%.

Since each project is independent and of average risk, all projects whose IRR > WACC will be
accepted. Consequently, Projects A, B, C, D, and E will be accepted and the optimal capital budget
is $5,250,000.

b. If Projects C and D are mutually exclusive, the firm will select Project D rather than Project C,
because Project D’s NPV is greater than Project C’s NPV. So, the optimal capital budget is now
$4 million, and consists of Projects A, B, D, and E.

c. The appropriate costs of capital are 10.5% for low-risk projects, 12.5% for average-risk
projects, and 14.5% for high-risk projects. Since Project A is high risk, it will be rejected
(IRR = 14% < WACC = 14.5%). Projects B, C, D, and E are all average risk and will be
accepted since their returns exceed 12.5%. Projects F and G are low risk and will both be
accepted since their returns exceed 10.5%. Therefore, the optimal capital budget is $6 million
and consists of Projects B, C, D, E, F, and G.

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13-6 INVESTMENT TIMING OPTION The Bush Oil Company is deciding whether to drill for oil
on a tract of land that the company owns. The company estimates that the project will cost
$8 million today. Bush estimates that once drilled, the oil will generate positive cash flows
of $4 million a year at the end of each of the next 4 years. Although the company is fairly
confident about its cash flow forecast, it recognizes that if it waits 2 years, it will have
more information about the local geology as well as the price of oil. Bush estimates that if
it waits 2 years, the project will cost $9 million, and cash flows will continue for 4 years
after the initial investment is made. Moreover, if it waits 2 years, there is a 90% chance
that the cash flows will be $4.2 million a year for 4 years, and there is a 10% chance that
the cash flows will be $2.2 million a year for 4 years. Assume that all cash flows are
discounted at 10%.
a. If the company chooses to drill today, what is the project’s expected net present value?
b. Would it make sense to wait 2 years before deciding whether to drill? Explain.
c. What is the value of the investment timing option?
d. What disadvantages might arise from delaying a project such as this drilling
project?

13-6 a. 0 11% 1 2 3 4

-9 4.3 4.3 4.3 4.3

NPV = $4.3405 million.

b. Wait 2 years:
0 11%
1 2 3 4 5 6 NPV @ Yr. 0
| | | | | | |
5% Prob. 0 0 -12 2.4 2.4 2.4 2.4-$3.6962

| | | | | | |
95% Prob. 0 0 -12 4.4 4.4 4.4 4.41.3398

If the cash flows are only $2.4 million, the NPV of the project is negative and, thus, would not
be undertaken. The value of the option of waiting two years is evaluated as 0.05($0) +
0.95($1.3398) = $1.2728 million.

Since the NPV of waiting two years is less than going ahead and proceeding with the project
today, it makes sense to drill today.

c. The investment timing option has a value of $0. Since the difference between the project with
the option and the project without the option is negative, $1.2728 million – $4.3405 million =
-$3.0677 million, the option will not be exercised. In other words, the costs of delaying the
project outweigh the benefits gained by delaying and gathering more information.

d. There is a danger that oil prices will decline causing the company to receive lower revenues for
the oil it extracts, and there is a danger that the company will lose market share or the chance
to compete for new contracts as a result of waiting.

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