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Chapter 12 - Strategy and the Analysis of Capital Investments
12-56 Sensitivity Analysis; Equipment-Replacement Decision (45-60
minutes)
1. The maximum amount of annual variable operating expenses, pre-tax,
that would make this an attractive investment from a present-value
standpoint = $99,206 as follows:
Net investment outlay, time 0 = $460,000
Differential salvage value, e-o-y 6 = $90,000
Net investment outlay − PV of salvage differential = $409,197
Year PV factor s (@ 10%)
1 0.90909 (1 ÷ (1+0.10)1)
2 0.82645 (1 ÷ (1+0.10)2)
3 0.75131 etc.
4 0.68301
Therefore, maximum annual operating cost, new asset
2. Recalculation, based on an after-tax basis:
Combined (federal and state) income tax rate = 35.00%
After-tax WACC (discount rate) = 8.00%
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Chapter 12 - Strategy and the Analysis of Capital Investments
12-56 (Continued-1)
Gain/Loss on sale:
Selling price = $40,000
NBV = $60,000
Tax savings due to deductibility of loss = loss x tax
rate = $20,000 × 0.35 = $7,000
Net-of-tax initial investment outlay, time 0 =
Pretax amount – tax savings due to loss
Annual tax shield, existing asset = $3,500
Annual tax shield, replacement asset = $29,167 $25,667
PV of differential depreciation tax shield (@ 8%) =
$25,667 × 4.623 (see below) = $118,657
4 0.73503
5 0.68058
6 0.63017
4.62300
(above answer is rounded to three decimal places)
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Chapter 12 - Strategy and the Analysis of Capital Investments
12-56 (Continued-2)
PV of after-tax variable operating costs, replacement asset
=
after-tax net investment outlay − PV of after-tax differential
salvage values − PV of differential tax savings due to depreciation
PV of annuity = annuity amount × annuity factor
annuity amount = PV of annuity ÷ annuity factor
= $297,478 ÷ 4.623 = $64,347
Therefore, maximum annual after-tax variable operating expenses new
asset
3. Additional (i.e., strategic) factors that might bear upon this decision:
a) Are any competitors of the Mendoza Company contemplating a
similar investment? Would such investments by competitors pose a
strategic risk to the Mendoza Company?
b) Are there any environmental-management benefits associated with
the new equipment?
c) What would be the impact of the proposed investment on other non-
financial performance indicators, such as (1) on-time delivery
performance, (2) customer response times, or (3) process up time?
d) Is Mendoza competing on the basis of price? Would the proposed
investment allow the company to establish/maintain its position as a
low-cost competitor?
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Hill Education.
Chapter 12 - Strategy and the Analysis of Capital Investments
12-57 Present Value Analysis; Sensitivity Analysis; Spreadsheet Applications (60
Minutes)
1. The minimum volume of car sales, per year, in the six-year life of the plant that is
needed to make this proposed investment acceptable using NPV as decision
criterion is 197,234, as follows:
Note: The discount factors in Column D were calculated using the following equation:
PV factori = 1 ÷ (1 + r)i, where r = discount rate (WACC) and i = year (i = 1, 8).
Goal Seek Window:
After running GOAL-SEEK, the result is as follows:
12-96
Hill Education.
Chapter 12 - Strategy and the Analysis of Capital Investments
12-57 (Continued-1)
And the GOAL SEEK window will have changed to:
Check:
Discount
Volume
Cash Flows
Factor
Present
7 197.234 $690,319 0.375937040 $259,516
8 197.234 $690,319 0.326901774 $225,666
($0)
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Chapter 12 - Strategy and the Analysis of Capital Investments
12-57 (Conitnued-2)
2. Sensitivity analysis:
a. if the company’s pre-tax WACC is 16% (rather than 15%), then the
required annual volume changes to 203,155 units (% change =
3.00%), as follows:
Cash Discount Present
Year Flows (000s) Factor (@16%) Value (000s)
1 ($750,000) 0.862068966 ($646,552)
2 ($1,750,000) 0.743162901 ($1,300,535)
($1,947,087)
3 0.640657674
4 0.552291098
5 0.476113015
6 0.410442255
b. if the company’s pre-tax WACC is 14% (rather than 15%), then the
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Hill Education.
Chapter 12 - Strategy and the Analysis of Capital Investments
12-57 (Continued-3)
The above results were generated using the following GOAL SEEK entries:
2c. Sensitivity issue: based on the limited analysis above, it does not
appear that the results are very sensitive to the assumption
regarding the discount rate (WACC) used in the analysis. From the
3. Selected strategic considerations, including those related to risk
management, that would likely bear on this decision:
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Chapter 12 - Strategy and the Analysis of Capital Investments
12-57 (Continued-4)
a) Given volatility in the demand for fossil fuels, and wide price swings in
the cost of gasoline, are there any embedded options ("real options")
in this investment project?
b) A rather substantial investment outlay is required. How sensitive is the
decision to accept or reject the project with respect to required
volume?
c) Are the facilities being envisioned flexible in nature (which would allow
the company to quickly change/revise its product in response to
changes in consumer demand and preferences)?
d) Are there any risks associated with not investing in this new product?
That is, will there be associated effects on the company's existing
product line(s)?
e) Would the company be at competitive risk were it not to invest in the
new technology? That is, is this new-car option available to the
company's competitors? If these competitors invest in this area, would
the company be at strategic risk?
f) Does the company compete on the basis of product differentiation?
That is, is the new product consistent with the strategy the company is
pursuing? Will, for example, the new facilities allow for reduced
product-development times (i.e., increased speed to market) and/or
increased product quality, either of which would help the company
achieve its stated value proposition to its targeted customers.
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Chapter 12 - Strategy and the Analysis of Capital Investments
12-58 MACRS Depreciation and Capital-Budgeting Analysis; Sensitivity Analysis;
Spreadsheet Application (60 minutes)
1. The estimated after-tax NPV of this proposed investment is ($66,917), as follows:
Net investment outlay, time 0:
Purchase cost $500,000
Remodeling cost (25 units × $20,000 per unit) $500,000
Net investment outlay $1,000,000
After-tax cash inflow per year:
Pre-tax rental revenue, $500 units = 15 units × $500 × 12 = $90,000
Pre-tax rental revenue, $650 units = 10 units × $650 × 12 = $78,000
After-tax Cash Operating Expenses per Year:
Pre-tax expenses, $500 units ($90,000 × 0.16) = $14,400
Estimated NPV of Proposed Investment (@ 10% discount rate):
Net initial investment outlay, time 0 = ($1,000,000)
Plus: PV of after-tax rental revenues (9.427× $100,800) = $ 950,242
Plus: PV of MACRS depreciation tax savings
Note: the PV factor of 0.3372 for 27.5-year residential rental property is given in the
problem, but can be calculated as follows:
PV27YR = [ (t * Dep%i) ÷ (1+r)i] ÷ 100, where t = tax rate, Dep% = MACRS
depreciation rate (e.g., from Exhibit 12.4), r = WACC (discount rate), and i =
1,28.The MACRS depreciation rates for 27.5-year property must be obtained outside
the text (they are not disclosed in Exhibit 12.4.)
2. Sensitivity analysis:
a. If the discount rate were 8% (rather than 10%), the estimated NPV of the project
is now positive, as follows:
MACRS depreciation per year, first 27 years = 3.636%
Chapter 12 - Strategy and the Analysis of Capital Investments
12-58 (Continued-1)
Tax Savings
Present Value of MACRS Depreciation Deductions
PV Factors PV of Tax Savings
Year Tax Savings 8% 12% 8% 12%
1 $14,545 0.926 0.893 $ 13,468 $ 12,987
2 $14,545 0.857 0.797 $ 12,470 $ 11,596
3 $14,545 0.794 0.712 $ 11,547 $ 10,353
4 $14,545 0.735 0.636 $ 10,691 $ 9,244
5 $14,545 0.681 0.567 $ 9,899 $ 8,253
6 $14,545 0.630 0.507 $ 9,166 $ 7,369
7 $14,545 0.583 0.452 $ 8,487 $ 6,580
8 $14,545 0.540 0.404 $ 7,858 $ 5,875
9 $14,545 0.500 0.361 $ 7,276 $ 5,245
15 $14,545 0.315 0.183 $ 4,585 $ 2,657
16 $14,545 0.292 0.163 $ 4,246 $ 2,373
17 $14,545 0.270 0.146 $ 3,931 $ 2,118
18 $14,545 0.250 0.130 $ 3,640 $ 1,891
19 $14,545 0.232 0.116 $ 3,370 $ 1,689
25 $14,545 0.146 0.059 $ 2,124 $ 856
26 $14,545 0.135 0.053 $ 1,967 $ 764
27 $14,545 0.125 0.047 $ 1,821 $ 682
28 $7,273 0.116 0.042 $ 843 $ 305
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