Financial management paper 3

You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago for $2.1 million in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $2.3 million on as an after tax basis. In four years, the land could be sold for $2.4 million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $125,000. An excerpt of the marketing report as follows: 

The zither industry will have a rapid expansion in the next four years. With the brand name recognition that PUTZ brings to bear, we feel that the company will be able to sell 3,600, 4,300, 5,200, and 3,900 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $750 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued. 

PUTZ believes that fixed costs for the project will be $415,000 per year, and variable costs are 15 percent of sales. The equipment necessary for production will cost $3.5 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $350,000. Net working capital of $125,000 will be required immediately. PUTZ has a 38 percent tax rate, and the required return on the project is 13 percent. What is the NPV of the project? 

Provide your explanations and definitions in detail and be precise. Explain in your own words. Provide references for content when necessary. Support your statements with peer-reviewed intext citation(s) and reference(s). 

2

>Build a Model Solution 8/

1 3

/15

Note: when creating student version, be sure

to

delete

Scenario

Summary

worksheet. Also delete the

Best

and Worse case scenarios

from

the Scenario Manager. Also delete this message in the student version.

Chapter: 11 Estimating Cash Flows and Analyzing Risk Problem: 18 Webmasters.com has developed a powerful new server that would be used for corporations’ Internet activities. It would cost $1

0

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 in an amount equal to

1

0%

of the year’s projected sales; for example, NWC0 =

10%

(

Sales

1). The servers would sell for $2

4

,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 will increase at the inflation rate of 3%. The company’s 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 project’s returns are expected to be highly correlated with returns on the firm’s 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 project’s 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 of

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 project’s NPV, IRR, and payback. Input Data (in thousands of dollars) Equipment cost $10,000 Key Results: Net operating working capital/Sales

10%

NPV = $3,463 First year sales (in units)

1,000

IRR = 21.1% Sales price per unit $24.00 Payback = 2.90 Variable

cost per unit (excl. depr.) $17.50 Nonvariable costs (excl. depr.) $1,000 Market value of equipment at Year 4

$500
Tax rate

40%
WACC 10%
Inflation in prices and costs 3.0% Estimated salvage value at year 4

$500
Intermediate Calculations

0 1 2 3 4
Unit

s sold

1,000 1,000 1,000 1,000
Sales price per unit (excl. depr.)

$24.00

$24.72 $25.46 $26.23 Variable costs

per unit (excl. depr.)

$17.50

$18.03 $18.57 $19.12 Nonvariable costs (excl. depr.) 1,000

1,030 1,061 1,093 Sales revenue $24,000 $24,720 $25,462 $26,225 Required level of net operating working capital $2,400 $2,472 $2,546 $2,623 $0 Basis for depreciation

$10,000
Annual equipment depr. rate 2

0.00

% 32.00% 19.

20% 11.52% Annual depreciation expense $

2,000 $

3,200 $

1,920 $

1,152 Ending Bk Val: Cost – Accum Dep’rn

$10,000

$8,000 $4,

800 $2,880 $1,728 Salvage value

$500
Profit (or loss) on salvage -$1,228 Tax on profit (or loss) -$491 Net cash flow

due to salvage $991 Years Cash Flow Forecast

0 1 2 3 4

Sales revenue $24,000 $24,720 $25,462 $26,225

Variable costs 17,500

18,025 18,566 19,123 Nonvariable operating costs

1,000 1,030 1,061 1,093
Depreciation (equipment)

2,000 3,200 1,920 1,152
Oper. income before taxes (EBIT) $3,500 $2,465 $3,915 $4,858 Taxes on operating income (40%) 1,400 986 1,566 1,943 Net operating profit after taxes $2,100 $1,479 $2,349 $2,915 Add back depreciation

2,000 3,200 1,920 1,152
Equipment purchases -$10,000 Cash flow due to change in NOWC -$2,400 -$72 -$74 -$76

$2,623

Net cash flow due to salvage $991

Net Cash Flow (Time line of cash flows) -$12,400 $4,028 $4,605 $4,193 $7,681 Key Results: Appraisal of the Proposed Project Net Present Value (at 10%) =

$3,463
IRR = 21.09% MIRR = 16.99% Payback =

2.90
Discounted Payback = 3.23 Data for Payback Years

Years
0 1 2 3 4
Net cash flow -$12,400 $4,028 $4,605 $4,193 $7,681
Cumulative CF

-$12,400

-$8,372 -$3,767 $425 $8,106 Part of year required for payback 1.00

1.00

0.90

0.00
Data for Discounted Payback Years

Years

0 1 2 3 4
Net cash flow -$12,400 $4,028 $4,605 $4,193 $7,681

Discounted cash flow

-$12,400

$3,662 $3,806 $3,150 $5,246 Cumulative CF -$12,400

-$8,738 -$4,933 -$1,783

$3,463
Part of year required for discounted payback

1.00 1.00 1.00

0.23 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. %

Deviation SALES 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 Sales

Price

in Cell B95 should be the number $24.00 you should NOT have the formula =D28 in that cell. This is because you’ll use D28 as the column input cell in the data table and if Excel tries to iteratively replace Cell D28 with the formula =D28 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! from

Base

NPV
Base Case

$24.00 $3,463
-20% $19.20 -$5,893 -10% $21.60 -$1,215 0% $24.00 $3,463
10%

$26.40 $8,141 20%

$28.80 $12,820 % Deviation

VARIABLE COST

% Deviation

1st YEAR UNIT SALES from Base NPV from Base NPV
Base Case $17.50 $3,463 Base Case 1,000 $3,463
-20%

$14.00 $10,401

-20% 800

$1,045 -10%

$15.75 $6,932

-10%

900 $2,254 0% $17.50 $3,463 0% 1,000 $3,463
10%

$19.25 -$6

10%

1,100 $4,673 20%

$21.00 -$3,475

20%

1,200 $5,882 Deviation

NPV at Different Deviations from Base from Sales Variable
Base Case Price

Cost/Unit Units Sold -20% -$5,893 $10,401 $1,045
-10% -$1,215 $6,932 $2,254
0% $3,463 $3,463 $3,463
10% $8,141 -$6 $4,673
20% $12,820 -$3,475 $5,882
Range $18,712 $13,876 $4,837 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. Sales Unit Variable
Scenario

Probability

Price Sales

Costs

NPV
Best Case

25% $28.80 1,200 $14.00

$25,435 Base Case 50% $24.00 1,000 $17.50 $3,463
Worst

Case

25% $19.20 800 $21.00

($11,990) Expected NPV = $5,093 Standard Deviation = $13,332 Coefficient of Variation = Std Dev / Expected NPV = 2.62 d. If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and payback. CV range of firm’s average-risk project:

0.8 to 1.2
Low-risk

WACC =

8%
WACC = 10%
High-risk WACC =

13%
Risk-adjusted WACC =

13%
Risk adjusted NPV = $2,387 IRR =

21.09%
Kenneth D. Jackson: IRR does not change. Payback =

2.90
Kenneth D. Jackson: Paypack does not change. e. On the basis of information in the problem, would you recommend that the project be accepted? At this point, the project looks risky but acceptable. There is a good chance that it will produce a positive NPV, but there is also a chance that the NPV could be quite low. The problem gave no information about the size of the project relative to the total corporation. If the company were quite large, and this were but one of many projects, and if the projects were independent of one another, then it should be accepted. However, if the firm were relatively small, and this project under bad conditions could bankrupt the company, then the decision is not clear. If management is highly risk averse, they might turn it down. However, well-diversified investors would probably prefer to see it accepted. So, to maximize the stock price, it should be accepted. We indicate in the problem that this project’s returns will tend to be highly correlated with the firm’s other projects’ returns. Thus, its stand-alone risk (which is what we have been analyzing) also reflects its within-firm risk. If this were not true, then we would need to make further risk adjustments.

Sensitivity Analysis

Sales price -0.2 -0.1 0 0.1 0.2 -5892.876254354208 -1214.7695184755212 3463.3372174031774 8141.4439532818797 12819.550689160566 VC -0.2 -0.1 0 0.1 0.2 10401.207376545313 6932.2722969742463 3463.3372174031774 -5.5978621678877971 -3474.5329417389548 Units -0.2 -0.1 0 0.1 0.2 1044.9939047879197 2254.1655610955495 3463.3372174031774 4672.5088737108053 5881.6805300184315

Percentage Deviation from Base

NPV ($)

Scenario Summary Scenario Summary

Base Best Worst

Created by Michael C. Ehrhardt on 11/13/2001

1,000 1,000 1,200 800

$24.00 $24.00 $28.80 $19.20

$17.50 $17.50 $14.00 $21.00

$3,463 $3,463 $25,435 ($11,990)

21.09% 21.09%

16.99% 16.99%

Current Values:
	Created by Michael C. Ehrhardt on 11/13/2001	Created by Michael C. Ehrhardt on 11/13/2001 Modified by Michael C. Ehrhardt on 11/13/2001
Changing Cells:
$D$29
$D$30
$D$31
Result Cells:
$D$79
$D$80	76.96%	ERROR:#NUM!
$D$81	43.42%	-41.46%
Notes: Current Values column represents values of changing cells at
time Scenario Summary Report was created. Changing cells for each
scenario are highlighted in gray.