276 Part Three Best Practices in Capital Budgeting
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payoff in the second year is only $220,000. Think of the payoffs in the second year as the cash
flow that year plus the year-2 value of any subsequent cash flows. Also think of these cash flows
as certainty equivalents, which can therefore be discounted at the risk-free interest rate of 10%.Ms.Magna now has an idea: Why not start out with one piston-engine plane. If demand is
low in the first year, Magna Charter can sit tight with this one relatively inexpensive aircraft.
On the other hand, if demand is high in the first year she can buy a second piston-engine
plane for only $150,000. In this case, if demand continues to be high, the payoff in year 2
from the two piston planes will be $800,000. However, if demand in year 2 were to decline,
the payoff would be only $100,000.
a. Draw a decision tree setting out Magna Charter’s choices.
b. If Magna Charter buys a piston plane, should it expand if demand turns out to be high in
the first year?
c. Given your answer to b, would you recommend that Ms. Magna buy the turboprop or the
piston-engine plane today?
d. What would be the NPV of an investment in a piston plane if there were no option to
expand? How much extra value is contributed by the option to expand?- Project analysis New Energy is evaluating a new biofuel facility. The plant would cost
$4,000 million to build and has the potential to produce up to 40 million barrels of syn-
thetic oil a year. The product is a close substitute for conventional oil and would sell for the
same price. The market price of oil currently is fluctuating around $100 per barrel, but there
is considerable uncertainty about future prices. Variable costs for the organic inputs to the
production process are estimated at $82 per barrel and are expected to be stable. In addition,
annual upkeep and maintenance expenses on the facility will be $100 million regardless of
the production level. The plant has an expected life of 15 years, and it will be depreciated
using MACRS and a 10-year recovery period. Salvage value net of clean-up costs is expected
to be negligible. Demand for the product is difficult to forecast. Depending on consumer
acceptance, sales might range from 25 million to 35 million barrels annually. The discount
rate is 12% and New Energy’s tax bracket is 35%.
a. Find the project NPV for the following combinations of oil price and sales volume. Which
source of uncertainty seems most important to the success of the project?
Oil Price
Annual Sales (millions of barrels) $80/Barrel $100/Barrel $120/Barrel
25
30
35b. At an oil price of $100, what level of annual sales, maintained over the life of the plant, is
necessary for NPV break-even? (This will require trial and error unless you are familiar
with more advanced features of Excel such as the Goal Seek command.)
c. At an oil price of $100, what is the accounting break-even level of sales in each year? Why
does it change each year? Does this notion of break-even seem reasonable to you?
d. If each of the scenarios in the table in part (a) is equally likely, what is the NPV of the facility?
e. Why might the facility be worth building despite your answer to part (d)? (Hint: What real
option may the firm have to avoid losses in low-oil-price scenarios?)- Monte Carlo simulation Look back at the guano project in Section 6-2. Use the Crystal
Ball™ software to simulate how uncertainty about inflation could affect the project’s cash flows.