388 Part 4 Investing in Long-Term Assets: Capital Budgeting
• (^) Real options enable " rms to take actions to alter the originally forecasted cash
! ows after a project is in operation. These options can increase NPVs.
• (^) The post-audit, which compares the project’s actual performance to its expected
results, is an important part of the capital budgeting process.
KEY TERMS Define the following terms:
a. Incremental cash flow; sunk cost; opportunity cost; externality; cannibalization
b. Stand-alone risk; corporate (within-firm) risk; market (beta) risk
c. Risk-adjusted cost of capital
d. Sensitivity analysis; base-case NPV
e. Scenario analysis; base-case scenario; worst-case scenario; best-case scenario
f. Monte Carlo simulation
g. Real option; abandonment option; decision tree
h. Option value
i. Optimal capital budget; capital rationing
j. Post-audit
PROJECT AND RISK ANALYSIS As a financial analyst, you must evaluate a proposed
project to produce printer cartridges. The equipment would cost $55,000, plus $10,000
for installation. Annual sales would be 4,000 units at a price of $50 per cartridge, and the
project’s life would be 3 years. Current assets would increase by $5,000 and payables
by $3,000. At the end of 3 years, the equipment could be sold for $10,000. Depreciation
would be based on the MACRS 3-year class; so the applicable rates would be 33%, 45%,
15%, and 7%. Variable costs would be 70% of sales revenues, fixed costs excluding
depreciation would be $30,000 per year, the marginal tax rate is 40%, and the corporate
WACC is 11%.
a. What is the required investment, that is, the Year 0 project cash flow?
b. What are the annual depreciation charges?
c. What are the project’s annual net cash flows?
d. If the project is of average risk, what is its NPV? Should it be accepted?
e. Suppose management is uncertain about the exact unit sales. What would the
project’s NPV be if unit sales turned out to be 20% below forecast but other inputs
were as forecasted? Would this change the decision? Explain.
f. The CFO asks you to do a scenario analysis using these inputs:
Probability Unit Sales VC%
Best case 25% 4,800 65%
Base case 50 4,000 70
Worst case 25 3,200 75
Other variables are unchanged. What are the expected NPV, its standard deviation,
and the coefficient of variation? [Hint: To do the scenario analysis, you must change
unit sales and VC% to the values specified for each scenario, get the scenario cash
flows, and then find each scenario’s NPV. Then you must calculate the project’s
expected NPV, standard deviation (SD), and coefficient of variation (CV). This is not
difficult, but it requires many calculations. You might want to look at the answer, but
make sure you understand how it was computed.]
g. The firm’s project CVs generally range from 1.0 to 1.5. A 3% risk premium is added
to the WACC if the initial CV exceeds 1.5, and the WACC is reduced by 0.5% if the CV