1、 The NPV of testing computed at date 0 (in millions) is:Because the NPV is positive, the firm should test the market for solar-powered jet engines.Warning We have used a discount rate of 15 percent for both the testing and the investment decisions. Perhaps a higher discount rate should have been use
2、d for the initial test marketing decision, which is likely to be riskier than the investment decision. Recap As mentioned above, the analysis is graphed in Figure 7.8. As can be seen from the figure, SEC must make the following two decisions: 1. Whether to develop and test the solar-powered jet engi
3、ne. 2. Whether to invest for full-scale production following the results of the test. Using a decision tree, we answered the second question before we answered the first one. Decision trees represent the best approach to solving SECs problem, given the information presented so far in the text. Howev
4、er, we will examine a more sophisticated approach to valuing options in a later chapter. Though this approach was first used to value financial options traded on organized option exchanges, it can be used to value real options as well. Summary and Conclusions This chapter discussed a number of pract
5、ical applications of capital budgeting. 1. Though NPV is the best capital budgeting approach conceptually, it has been criticized in practice for giving managers a false sense of security. Sensitivity analysis shows NPV under varying assumptions, giving managers a better feel for the projects risks.
6、 Unfortunately, sensitivity analysis modifies only one variable at a time, but many variables are likely to vary together in the real world. Scenario analysis examines a projects performance under different scenarios (such as war breaking out or oil prices skyrocketing). Finally, managers want to kn
7、ow how bad forecasts must be before a project loses money. Break-even analysis calculates the sales figure at which the project breaks even. Though break-even analysis is frequently performed on an accounting profit basis, we suggest that a net present value basis is more appropriate. 2. Monte Carlo
8、 simulation begins with a model of the firms cash flows, based on both the interactions between different variables and the movement of each individual variable over time. Random sampling generates a distribution of these cash flows for each period, leading to a net present value calculation. 3. We
9、analyzed the hidden options in capital budgeting, such as the option to expand, the optionto abandon, and timing options. 4. Decision trees represent an approach for valuing projects with these hidden, or real, options. Concept Questions 1. Forecasting Risk What is forecasting risk? In general, woul
10、d the degree of forecasting risk be greater for a new product or a cost-cutting proposal? Why? 2. Sensitivity Analysis and Scenario Analysis What is the essential difference between sensitivity analysis and scenario analysis? 3. Marginal Cash Flows A coworker claims that looking at all this marginal
11、 this and incremental that is just a bunch of nonsense, and states, “Listen, if our average revenue doesnt exceed our average cost, then we will have a negative cash flow, and we will go broke!” How do you respond? 4. Break-Even Point As a shareholder of a firm that is contemplating a new project, w
12、ould you be more concerned with the accounting break-even point, the cash break-even point (the point at which operating cash flow is zero), or the financial break-even point? Why? 5. Break-Even Point Assume a firm is considering a new project that requires an initial investment and has equal sales
13、and costs over its life. Will the project reach the accounting, cash, or financial break-even point first? Which will it reach next? Last? Will this order always apply? 6. Real Options Why does traditional NPV analysis tend to underestimate the true value of a capital budgeting project? 7. Real Opti
14、ons The Mango Republic has just liberalized its markets and is now permitting foreign investors. Tesla Manufacturing has analyzed starting a project in the country and has determined that the project has a negative NPV. Why might the company go ahead with the project? What type of option is most lik
15、ely to add value to this project? 8. Sensitivity Analysis and Breakeven How does sensitivity analysis interact with break-even analysis? 9. Option to Wait An option can often have more than one source of value. Consider a logging company. The company can log the timber today or wait another year (or
16、 more) to log the timber. What advantages would waiting one year potentially have? 10. Project Analysis You are discussing a project analysis with a coworker. The project involves real options, such as expanding the project if successful, or abandoning the project if it fails. Your coworker makes th
17、e following statement: “This analysis is ridiculous. We looked at expanding or abandoning the project in two years, but there are many other options we should consider. For example, we could expand in one year, and expand further in two years. Or we could expand in one year, and abandon the project
18、in two years. There are too many options for us to examine. Because of this, anything this analysis would give us is worthless.” How would you evaluate this statement? Considering that with any capital budgeting project there are an infinite number of real options, when do you stop the option analys
19、is on an individual project? Questions and Problems: connect BASIC (Questions 110) 1. Sensitivity Analysis and Break-Even Point We are evaluating a project that costs $724,000, has an eight-year life, and has no salvage value. Assume that depreciation is straight- line to zero over the life of the p
20、roject. Sales are projected at 75,000 units per year. Price per unit is $39, variable cost per unit is $23, and fixed costs are $850,000 per year. The tax rate is 35 percent, and we require a 15 percent return on this project. 1. Calculate the accounting break-even point.2. Calculate the base-case c
21、ash flow and NPV. What is the sensitivity of NPV to changes in the sales figure? Explain what your answer tells you about a 500-unit decrease in projected sales. 3. What is the sensitivity of OCF to changes in the variable cost figure? Explain what your answer tells you about a $1 decrease in estima
22、ted variable costs. 2. Scenario Analysis In the previous problem, suppose the projections given for price, quantity, variable costs, and fixed costs are all accurate to within 10 percent. Calculate the best-case and worst-case NPV figures. 3. Calculating Breakeven In each of the following cases, fin
23、d the unknown variable. Ignore taxes.4. Financial Breakeven L.J.s Toys Inc. just purchased a $250,000 machine to produce toy cars. The machine will be fully depreciated by the straight-line method over its five-year economic life. Each toy sells for $25. The variable cost per toy is $6, and the firm
24、 incurs fixed costs of $360,000 each year. The corporate tax rate for the company is 34 percent. The appropriate discount rate is 12 percent. What is the financial break-even point for the project? 5. Option to Wait Your company is deciding whether to invest in a new machine. The new machine will in
25、crease cash flow by $340,000 per year. You believe the technology used in the machine has a 10-year life; in other words, no matter when you purchase the machine, it will be obsolete 10 years from today. The machine is currently priced at $1,800,000. The cost of the machine will decline by $130,000
26、per year until it reaches $1,150,000, where it will remain. If your required return is 12 percent, should you purchase the machine? If so, when should you purchase it? 6. Decision Trees Ang Electronics, Inc., has developed a new DVDR. If the DVDR is successful, the present value of the payoff (when
27、the product is brought to market) is $22 million. If the DVDR fails, the present value of the payoff is $9 million. If the product goes directly to market, there is a 50 percent chance of success. Alternatively, Ang can delay the launch by one year and spend $1.5 million to test market the DVDR. Tes
28、t marketing would allow the firm to improve the product and increase the probability of success to 80 percent. The appropriate discount rate is 11 percent. Should the firm conduct test marketing? 7. Decision Trees The manager for a growing firm is considering the launch of a new product. If the prod
29、uct goes directly to market, there is a 50 percent chance of success. For $135,000 the manager can conduct a focus group that will increase the products chance of success to 65 percent. Alternatively, the manager has the option to pay a consulting firm $400,000 to research the market and refine the
30、product. The consulting firm successfully launches new products 85 percent of the time. If the firm successfully launches the product, the payoff will be $1.5 million. If the product is a failure, the NPV is zero. Which action will result in the highest expected payoff to the firm?8. Decision Trees
31、B there are neither salvage value nor net working capital requirements. 1. At the accounting break-even level of output, what is the IRR of this project? The payback period? The NPV? 2. At the cash break-even level of output, what is the IRR of this project? The payback period? The NPV? 3. At the fi
32、nancial break-even level of output, what is the IRR of this project? The payback period? The NPV? 12. Sensitivity Analysis Consider a four-year project with the following information: Initial fixed asset investment = $380,000; straight-line depreciation to zero over the four-year life; zero salvage
33、value; price = $54; variable costs = $42; fixed costs = $185,000; quantity sold = 90,000 units; tax rate = 34 percent. How sensitive is OCF to changes in quantity sold? 13. Project Analysis You are considering a new product launch. The project will cost $960,000, have a four-year life, and have no s
34、alvage value; depreciation is straight-line to zero. Sales are projected at 240 units per year; price per unit will be $25,000; variable cost per unit will be $19,500; and fixed costs will be $830,000 per year. The required return on the project is 15 percent, and the relevant tax rate is 35 percent
35、.1. Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within 10 percent. What are the upper and lower bounds for these projections? What is the base-case NPV? What are the best-case and worst-case scenarios? 2. Evaluate
36、the sensitivity of your base-case NPV to changes in fixed costs. 3. What is the accounting break-even level of output for this project? 14. Project Analysis McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell for $750 per set and have a variable cost of $390 per set. The c
37、ompany has spent $150,000 for a marketing study that determined the company will sell 55,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 12,000 sets of its high-priced clubs. The high-priced clubs sell at $1,100 and have variable costs of $6
38、20. The company will also increase sales of its cheap clubs by 15,000 sets. The cheap clubs sell for $400 and have variable costs of $210 per set. The fixed costs each year will be $8,100,000. The company has also spent $1,000,000 on research and development for the new clubs. The plant and equipmen
39、t required will cost $18,900,000 and will be depreciated on a straight-line basis. The new clubs will also require an increase in net working capital of $1,400,000 that will be returned at the end of the project. The tax rate is 40 percent, and the cost of capital is 14 percent. Calculate the paybac
40、k period, the NPV, and the IRR. 15. Scenario Analysis In the previous problem, you feel that the values are accurate to within only 10 percent. What are the best-case and worst-case NPVs? (Hint: The price and variable costs for the two existing sets of clubs are known with certainty; only the sales
41、gained or lost are uncertain.) 16. Sensitivity Analysis McGilla Golf would like to know the sensitivity of NPV to changes in the price of the new clubs and the quantity of new clubs sold. What is the sensitivity of the NPV to each of these variables? 17. Abandonment Value We are examining a new proj
42、ect. We expect to sell 9,000 units per year at $50 net cash flow apiece for the next 10 years. In other words, the annual operating cash flow is projected to be $50 9,000 = $450,000. The relevant discount rate is 16 percent, and the initial investment required is $1,900,000. 1. What is the base-case
43、 NPV? 2. After the first year, the project can be dismantled and sold for $1,300,000. If expected sales are revised based on the first years performance, when would it make sense to abandon the investment? In other words, at what level of expected sales would it make sense to abandon the project? 3.
44、 Explain how the $1,300,000 abandonment value can be viewed as the opportunity cost of keeping the project in one year. 18. Abandonment In the previous problem, suppose you think it is likely that expected sales will be revised upward to 11,000 units if the first year is a success and revised downwa
45、rd to 4,000 units if the first year is not a success. 1. If success and failure are equally likely, what is the NPV of the project? Consider the possibility of abandonment in answering. 2. What is the value of the option to abandon? 19. Abandonment and Expansion In the previous problem, suppose the
46、scale of the project canbe doubled in one year in the sense that twice as many units can be produced and sold. Naturally, expansion would be desirable only if the project were a success. This implies that if the project is a success, projected sales after expansion will be 22,000. Again assuming tha
47、t success and failure are equally likely, what is the NPV of the project? Note that abandonment is still an option if the project is a failure. What is the value of the option to expand? 20. Break-Even Analysis Your buddy comes to you with a sure-fire way to make some quick money and help pay off yo
48、ur student loans. His idea is to sell T-shirts with the words “I get” on them. “You get it?” He says, “You see all those bumper stickers and T-shirts that say got milk or got surf. So this says, I get. Its funny! All we have to do is buy a used silk screen press for $3,200 and we are in business!” A
49、ssume there are no fixed costs, and you depreciate the $3,200 in the first period. Taxes are 30 percent. 1. What is the accounting break-even point if each shirt costs $7 to make and you can sell them for $10 apiece? Now assume one year has passed and you have sold 5,000 shirts! You find out that the Dairy Farmers of America have copyrighted the “got milk” slogan and are requiring you to pay $12,000 to continue operations. You expect this craze will last for another three years and that your discount rate is 12 percent. 2. What is the financial break-even point for your e
