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Ch11 P18 Build a Model

Webmasters.com is considering a $10 million investment in a server project expected to generate significant cash flows over four years, with sales of 1,000 units annually at a price of $24,000 each. The project involves variable and non-variable costs, depreciation, and requires net working capital tied to sales projections. A comprehensive financial analysis including NPV, IRR, payback, sensitivity, and scenario analyses will determine the project's viability and risk-adjusted returns.

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Eman Mudhafar
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4 views

Ch11 P18 Build a Model

Webmasters.com is considering a $10 million investment in a server project expected to generate significant cash flows over four years, with sales of 1,000 units annually at a price of $24,000 each. The project involves variable and non-variable costs, depreciation, and requires net working capital tied to sales projections. A comprehensive financial analysis including NPV, IRR, payback, sensitivity, and scenario analyses will determine the project's viability and risk-adjusted returns.

Uploaded by

Eman Mudhafar
Copyright
© © All Rights Reserved
Available Formats
Download as XLSX, PDF, TXT or read online on Scribd
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Solution 8/13/2015

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 $10 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 10% of the year's projected sales; for
example, NWC0 = 10%(Sales1). The servers would sell for $24,000 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 =
First year sales (in units) 1,000 IRR =
Sales price per unit $24.00 Payback =
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
Units sold
Sales price per unit (excl. depr.)
Variable costs per unit (excl. depr.)
Nonvariable costs (excl. depr.)
Sales revenue
Required level of net operating working capital
Basis for depreciation $10,000
Annual equipment depr. rate 20.00% 32.00% 19.20% 11.52%
Annual depreciation expense
Ending Bk Val: Cost – Accum Dep'rn $10,000

Page 1
Salvage value $500
Profit (or loss) on salvage
Tax on profit (or loss)
Net cash flow due to salvage
Years
Cash Flow Forecast 0 1 2 3 4
Sales revenue
Variable costs
Nonvariable operating costs
Depreciation (equipment)
Oper. income before taxes (EBIT)
Taxes on operating income (40%)
Net operating profit after taxes
Add back depreciation
Equipment purchases
Cash flow due to change in NOWC
Net cash flow due to salvage
Net Cash Flow (Time line of cash flows)

Key Results: Appraisal of the Proposed Project

Net Present Value (at 10%) =


IRR =
MIRR =
Payback =
Discounted Payback =
Data for Payback Years Years
0 1 2 3 4
Net cash flow
Cumulative CF
Part of year required for payback

Data for Discounted Payback Years Years


0 1 2 3 4
Net cash flow
Discounted cash flow
Cumulative CF
Part of year required for discounted payback

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
from Base NPV
NOT be input using a cell reference to the column input cell.
Base Case $24.00 For example, the base case Sales Price in Cell B95 should be
-20% the number $24.00 you should NOT have the formula =D28 in
-10% 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
Pagetell2 you that there is a problem, so you'll just get the
wrong values for the data table!
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
0% cell in the data table and if Excel tries to iteratively replace Cell
10% D28 with the formula =D28 rather than a series of numbers,
20% 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!

% Deviation VARIABLE COST % Deviation 1st YEAR UNIT SALES


from Base NPV from Base NPV
Base Case $17.50 Base Case 1,000
-20% -20%
-10% -10%
0% 0%
10% 10%
20% 20%

Page 3
Deviation NPV at Different Deviations from Base
from Sales Variable
Base Case Price Cost/Unit Units Sold
-20% $0 $0 $0
-10% $0 $0 $0
0% $0 $0 $0
10% $0 $0 $0
20% $0 $0 $0

Range

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.

Page 4
Sales Unit Variable
Scenario Probability Price Sales Costs NPV

Best Case 25% $28.80 1,200 $14.00


Base Case 50% $24.00 1,000 $17.50
Worst Case 25% $19.20 800 $21.00

Expected NPV =
Standard Deviation =
Coefficient of Variation = Std Dev / Expected NPV =

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 =
Risk adjusted NPV =
IRR =
Payback =

e. On the basis of information in the problem, would you recommend that the project be accepted?

Page 5
1,000
$24.00
$17.50

Page 6

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