CH 11 - CF Estimation Mini Case Sols Word 1514ed

Chapter 11(15th ed)
Cash Flow Estimation

and Risk Analysis
ANSWERS
MINI CASE
Shrieves Casting Company is considering adding a new line to its product mix, and the capital
budgeting analysis is being conducted by Sidney Johnson, a recently graduated MBA. The
production line would be set up in unused space in Shrieves’ 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 equipment. 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 years of use.
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 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 is 10%.
a. Define “incremental cash flow.”
Answer: This is the firm’s cash flow with the project minus the firm’s cash flow without the
project.
a. 1. Should you subtract interest expense or dividends when calculating project cash
flow?
Answer: The cash flow statement should not include interest expense or dividends. The return
required by the investors furnishing the capital is already accounted for when we apply
the 10% cost of capital discount rate; hence, including financing flows would be
“double counting.” Put another way, if we deducted capital costs in the table, and thus
reduced the bottom-line cash flows, and then discounted those CFs by the cost of
capital, we would, in effect, be subtracting capital costs twice.
Mini Case: 11 - 1
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a. 2. Suppose the firm had spent $100,000 last year to rehabilitate the production line
site. Should this cost be included in the analysis? Explain.
Answer: The $100,000 cost to rehabilitate the production line site was incurred last year, and
presumably also expensed for tax purposes. Since, it is a sunk cost, it should not be
included in the analysis.
a. 3. Now assume that the plant space could be leased out to another firm at $25,000 per
year. Should this be included in the analysis? If so, how?
Answer: If the plant space could be leased out to another firm, then if Shrieves accepts this project,
it would forgo the opportunity to receive $25,000 in annual cash flows. This represents
an opportunity cost to the project, and it should be included in the analysis. Note that the
opportunity cost cash flow must be net of taxes, so it would be a $25,000(1 – T) =
$25,000(0.6) = $15,000 annual outflow.
a. 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?
Answer: If a project affects the cash flows of another project, this is an “externality” that must be
considered in the analysis. If the firm's sales would be reduced by $50,000, then the net
cash flow loss would be a cost to the project. Note that this annual loss would not be the
full $50,000, because Shrieves would save on cash operating costs if its sales dropped.
Note also that externalities can be positive as well as negative.
b. Disregard the assumptions in part a. What is Shrieves’ depreciable basis? What

are the annual depreciation expenses?
Answer: The asset’s depreciable basis includes shipping and installation costs. Thus, the asset’s
depreciable basis = $200,000 + $10,000 + $30,000 = $240,000. Get the depreciation
rates from Table 11A-2 in the book. Note that because of the half-year convention, a
3-year project is depreciated over 4 calendar years:
(Dollars in Thousands)
Year Rate  Basis = Depreciation
1 0.3333 $240 $ 80
2 0.4445 240 107
3 0.1481 240 35
4 0.0741 240 18
$240
Mini Case: 11 - 2
c. Calculate the annual sales revenues and costs (other than depreciation). Why is it
important to include inflation when estimating cash flows?
Answer: With an inflation rate of 3%, the annual revenues and costs are:
Year 1 Year 2 Year 3 Year 4

Units 1,250 1,250 1,250 1,250
Unit Price $200.00 $206.00 $212.18 $218.55
Unit Cost $100.00 $103.00 $106.09 $109.27
Sales $250,000 $257,500 $265,225 $273,188

Costs $125,000 $128,750 $132,613 $136,588
The cost of capital is a nominal cost; i.e., it includes a premium for inflation. In other
words, it is larger than the real cost of capital. Similarly, nominal cash flows (those that
are inflated) are larger than real cash flows. If you discount the low, real cash flows with
the high, nominal rate, then the resulting NPV is too low. Therefore, you should always
discount nominal cash flows with a nominal rate, and real cash flows with a real rate. In
theory, you could do the analysis either way and obtain the correct answer. However,
there is no accurate way to convert a nominal cost of capital to a real cost. Therefore,
you should inflate cash flows and then discount at the nominal cost of capital.
d. Construct annual incremental operating cash flow statements.
Answer:
Year 1 Year 2 Year 3 Year 4
Sales $250,000 $257,500 $265,225 $273,188
Costs 125,000 128,750 132,613 136,588
Depreciation 79,992 106,680 35,544 17,784
Op. EBIT $45,008 $22,070 $97,069 $118,807
Taxes (40%) 18,003 8,828 38,827 47,523
EBIT(1 – T) $27,005 $13,242 $58,241 $71,284
Depreciation 79,992 106,680 35,544 17,784
Net Operating CF $106,997 $119,922 $93,785 $89,068
Mini Case: 11 - 3
e. Estimate the required net working capital for each year, and the cash flow due to
investments in net working capital.
Answer: The project requires a level of net working capital in the amount equal to 12% of the next
year’s sales. Any increase in NWC is a negative cash flow, and any decrease is a positive
cash flow. This project has a 4-year operating life, so any NWC expenditures will be
recovered in Year 4. (That is, accounts receivables are received and inventories are
drawn down.)
Year 0 Year 1 Year 2 Year 3 Year 4

Sales $250,000 $257,500 $265,225 $273,188
NWC (12% of sales) $30,000 $30,900 $31,827 $32,783 $0
CF due to NWC ($30,000) ($900) ($927) ($956) $32,783
f. Calculate the after-tax salvage cash flow.
Answer: When the project is terminated at the end of Year 4, the equipment can be sold for
$25,000. But, since it has been depreciated to a $0 book value, taxes must be paid on the
full salvage value. For this project, the after-tax salvage cash flow is:
Salvage Value $25,000

Tax on Salvage Value (10,000)
Net After-Tax Salvage Cash Flow $15,000
Mini Case: 11 - 4
g. Calculate the net cash flows for each year. Based on these cash flows, what are the
project’s NPV, IRR, MIRR, PI, payback, and discounted payback? Do these
indicators suggest the project should be undertaken?
Answer: The net cash flows are:
Year 0 Year 1 Year 2 Year 3 Year 4

Initial Outlay ($240,000
)
Operating Cash Flows $106,997 $119,922 $93,785 $89,068
CF due to NWC (30,000) (900) (927) (956) 32,783
Salvage Cash Flows 15,000
Net Cash Flows ($270,000 $106,097 $118,995 $92,830 $136,850
)
NPV = $88,010
IRR = 23.9%
MIRR = 18.0%
Payback = 2.5
h. What does the term “risk” mean in the context of capital budgeting; to what extent
can risk be quantified; and when risk is quantified, is the quantification based
primarily on statistical analysis of historical data or on subjective, judgmental
estimates?
Answer: Risk throughout finance relates to uncertainty about future events, and in capital
budgeting, this means the future profitability of a project. For certain types of projects, it
is possible to look back at historical data and to statistically analyze the riskiness of the
investment. This is often true when the investment involves an expansion decision; for
example, if Sears were opening a new store, if Citibank were opening a new branch, or
if GM were expanding its Chevrolet plant, then past experience could be a useful guide
to future risk. Similarly, a company that is considering going into a new business might
be able to look at historical data on existing firms in that industry to get an idea about the
riskiness of its proposed investment. However, there are times when it is impossible to
obtain historical data regarding proposed investments; for example, if GM were
considering the development of an electric auto, not much relevant historical data for
assessing the riskiness of the project would be available. Rather, GM would have to rely
primarily on the judgment of its executives, and they, in turn would have to rely on their
experience in developing, manufacturing, and marketing new products. We will try to
quantify risk analysis, but you must recognize at the outset that some of the data used in
Mini Case: 11 - 5
the analysis will necessarily be based on subjective judgments rather than on hard
statistical observations.
i. 1. What are the three types of risk that are relevant in capital budgeting?
2. How is each of these risk types measured, and how do they relate to one another?
Answer: Here are the three types of project risk:
 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 measured either by the project’s standard deviation of
NPV (σNPV) or its coefficient of variation of NPV (CVNPV). Note that other profitability
measures, such as IRR and MIRR, can also be used to obtain stand-alone risk estimates.
 Within-firm risk is the total riskiness of the project giving consideration to the firm’s
other projects, that is, to diversification within the firm. It is the contribution of the
project to the firm’s total risk, and it is a function of (a) the project’s standard deviation
of NPV and (b) the correlation of the projects’ returns with those of the rest of the firm.
Within-firm risk is often called corporate risk, and it is measured by the project’s
corporate beta, which is the slope of the regression line formed by plotting returns on the
project versus returns on the firm.
 Market risk is the riskiness of the project to a well-diversified investor, hence it considers
the diversification inherent in stockholders’ portfolios. It is measured by the project’s
market beta, which is the slope of the regression line formed by plotting returns on the
project versus returns on the market.
i. 3. How is each type of risk used in the capital budgeting process?
Answer: Because management’s primary goal is shareholder wealth maximization, the most
relevant risk for capital projects is market risk. However, creditors, customers, suppliers,
and employees are all affected by a firm’s total risk. Since these parties influence the
firm’s profitability, a project’s within-firm risk should not be completely ignored.
Unfortunately, by far the easiest type of risk to measure is a project’s stand-alone
risk. Thus, firms often focus on this type of risk when making capital budgeting
decisions. However, this focus does not necessarily lead to poor decisions, because most
projects that a firm undertakes are in its core business. In this situation, a project’s stand-
alone risk is likely to be highly correlated with its within-firm risk, which in turn is likely
to be highly correlated with its market risk.
Mini Case: 11 - 6
j. 1. What is sensitivity analysis?
Answer: Sensitivity analysis measures the effect of changes in a particular variable, say revenues,
on a project’s NPV. To perform a sensitivity analysis, all variables are fixed at their
expected values except one. This one variable is then changed, often by specified
percentages, and the resulting effect on NPV is noted. (One could allow more than one
variable to change, but this then merges sensitivity analysis into scenario analysis.)
j. 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 expected,
value by 10%, 20%, and 30%. Include a sensitivity diagram, and discuss the
results.
Answer: The sensitivity data are given here in tabular form:
NPV Deviation from

Deviation Base Case
from Units
Base Case WACC Sold Salvage
-30% $113,270 $16,649 $84,936
-15% 100,291 52,329 86,473
0% 88,010 88,010 88,010
15% 76,378 123,690 89,546
30% 65,350 159,371 91,083
Range $47,920 $176,020 $6,147
We generated these data with a spreadsheet model in the file Ch11 Mini Case Model.xls.
Mini Case: 11 - 7
Sensitivity Analysis
NPV ($)
180,000
Units Sold
160,000
140,000
120,000
Salvage Value
100,000
80,000
60,000
WACC
40,000
20,000
0
-40% -20% 0% 20% 40%
Deviation from Base-Case Value
A. The sensitivity lines intersect at 0% change and the base-case NPV, $88,030. Since
all other variables are set at their base-case, or expected, values the zero change
situation is the base case and gives the base-case NPV, $88,030.
B. The plots for unit sales and salvage value are upward sloping, indicating that higher
variable values lead to higher NPVs. Conversely, the plot for cost of capital is
downward sloping, because a higher cost of capital leads to a lower NPV.
C. The plot of unit sales is much steeper than that for salvage value. This indicates that
NPV is more sensitive to changes in unit sales than to changes in salvage value.
D. Steeper sensitivity lines indicate greater risk. Thus, in comparing two projects, the
one with the steeper sensitivity lines is considered to be the riskier project.
Mini Case: 11 - 8
j. 3. What is the primary weakness of sensitivity analysis? What is its primary
usefulness?
Answer: The two primary disadvantages of sensitivity analysis are (1) that it does not reflect the
effects of diversification and (2) that it does not incorporate any information about the
possible magnitudes of the forecast errors. Thus, a sensitivity analysis might indicate
that a project’s NPV is highly sensitive to the sales forecast; hence, that the project is
quite risky, but if the project’s sales, hence its revenues, are fixed by a long-term contract,
then sales variations may actually contribute little to the project’s risk. It also ignores any
relationships between variables, such as unit sales and sales price.
Therefore, in many situations, sensitivity analysis is not a particularly good risk
indicator. However, sensitivity analysis does identify those variables that potentially
have the greatest impact on profitability, and this helps management focus its attention
on those variables that are probably most important.
k. Assume that Sidney Johnson is confident of 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. Sidney believes that there is a 25% chance of poor
acceptance, a 25% chance of excellent acceptance, and a 50% chance of average
acceptance (the base case).
k. 1. What is scenario analysis?
Answer: Scenario analysis examines several possible situations, usually worst case, most likely
case, and best case. It provides a range of possible outcomes.
Mini Case: 11 - 9
k. 2. What is the worst-case NPV? The best-case NPV?
k. 3. Use the worst-, base-, and best-case NPVs and probabilities of occurrence to find
the project’s expected NPV, standard deviation, and coefficient of variation.
Answer: We used a spreadsheet model to develop the scenarios, which are summarized below:
Scenario Probability Unit Sales Unit Price NPV

Best Case 25% 1,600 $240 $278,940
Base Case 50% 1,250 $200 $88,010
Worst Case 25% 900 $160 ($48,527)
Expected NPV = $101,608
Standard Deviation = $116,573
Coefficient of Variation =
Std. Dev./Expected NPV = 1.15
l. Are there problems with scenario analysis? Define simulation analysis, and discuss
its principal advantages and disadvantages.
Answer: Scenario analysis examines several possible scenarios, usually worst case, most likely
case, and best case. Thus, it usually considers only 3 possible outcomes. Obviously the
world is much more complex, and most projects have an almost infinite number of
possible outcomes.
Simulation analysis is a type of scenario analysis that uses randomly generated inputs
rather than specific values. Here the uncertain cash flow variables (such as unit sales) are
entered as continuous probability 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 of the variable values
have been selected, they are combined and an NPV is calculated. The process is repeated
many times, say 1,000 times, with new values selected from the distributions for each
run. The end result is a probability distribution of NPV based on a sample of 1,000
values. Simulation can provide the distribution as well as summary statistics such as
expected NPV and σNPV. Simulation provides the decision maker with a better idea of
the profitability of a project than does scenario analysis because it incorporates many
more possible outcomes.
Mini Case: 11 - 10
Although simulation analysis is technically refined, its usefulness is limited because
managers are often unable to accurately specify the variables’ probability distributions.
Further, the correlations among the uncertain variables must be specified, along with the
correlations over time. If managers are unable to do this with much confidence, then the
results of simulation analyses are of limited value.
Recognize also that neither sensitivity, scenario, nor simulation analysis provides a
decision rule—they may indicate that a project is relatively risky, but they do not indicate
whether the project’s expected return is sufficient to compensate for its risk.
Finally, remember that sensitivity, scenario, and simulation analyses all focus on
stand-alone risk, which is not the most relevant risk in capital budgeting analysis.
m. 1. Assume that Shrieves’ average project has a coefficient of variation in the range of
0.2 to 0.4. Would the new line be classified as high risk, average risk, or low risk?
What type of risk is being measured here?
Answer: The project has a CV of 1.15, which is above the average range of 0.2 to 0.4, so it falls
into the high-risk category. The CV measures a project’s stand-alone risk; it is merely a
measure of the variability of returns (as measured by NPV) about the expected return.
m. 2. Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital
to adjust for risk. Should the new line be accepted?
Answer: Since the project is judged to have above-average risk, its differential risk-adjusted, or
project, cost of capital would be 13%. At this discount rate, its NPV would be $65,371,
so it would still be acceptable. If it were a low-risk project, its cost of capital would be
7%, its NPV would be $113,288, and it would be an even more profitable project on a
risk-adjusted basis.
m. 3. Are there any subjective risk factors that should be considered before the final
decision is made?
Answer: A numerical analysis such as this one may not capture all of the risk factors inherent in
the project. If the project has a potential for bringing on harmful lawsuits, then it might
be riskier than first assessed. Also, if the project’s assets can be redeployed within the
firm or can be easily sold, then, as a result of “abandonment possibilities,” the project
may be less risky than the analysis indicates.
Mini Case: 11 - 11
n. What is a real option? What are some types of real options?
Answer: Real options exist when managers can influence the size and risk of a project’s cash flows
by taking different actions during the project’s life in response to changing market
conditions. Some types of real options are listed below:
1. Investment timing options

2. Growth options
a. Expansion of existing product line
b. New products
c. New geographic markets
3. Abandonment options
a. Contraction
b. Temporary suspension
c. Complete abandonment
4. Flexibility options
a. Inputs
b. Outputs
c. Both
Mini Case: 11 - 12
Mini Case: 11 - 13

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What are the different types of real options?

What are the different types of real options?

What factors should be considered in risk analysis?

What factors should be considered in risk analysis?

Chapter 11(15th ed)

Cash Flow Estimation

a. Define “incremental cash flow.”

b. Disregard the assumptions in part a. What is Shrieves’ depreciable basis? What

Year 1 Year 2 Year 3 Year 4

Sales $250,000 $257,500 $265,225 $273,188

d. Construct annual incremental operating cash flow statements.

Year 0 Year 1 Year 2 Year 3 Year 4

f. Calculate the after-tax salvage cash flow.

Salvage Value $25,000

Answer: The net cash flows are:

Year 0 Year 1 Year 2 Year 3 Year 4

Answer: Here are the three types of project risk:

i. 3. How is each type of risk used in the capital budgeting process?

Answer: The sensitivity data are given here in tabular form:

NPV Deviation from

Range $47,920 $176,020 $6,147

k. 1. What is scenario analysis?

Scenario Probability Unit Sales Unit Price NPV

1. Investment timing options

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