978-1259709685 Chapter 7 Solution Manual Part 2

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15. The upper and lower bounds for the variables are:

Base Case Best Case Worst Case

Unit sales (new) 60,000 66,000 54,000

Price (new) $850 $935 $765

Best-case

We will calculate the sales and variable costs first. Since we will lose sales of the expensive clubs

and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales for the new

project will be:

Sales

For the variable costs, we must include the units gained or lost from the existing clubs. Note that the

variable costs of the expensive clubs are an inflow. If we are not producing the sets any more, we

will save these variable costs, which is an inflow. So:

Var. costs

New clubs –$387  66,000 = –$25,542,000

The pro forma income statement will be:

Sales $56,430,000

Variable costs 22,311,000

Using the bottom up OCF calculation, we get:

And the best-case NPV is:

Worst-case

We will calculate the sales and variable costs first. Since we will lose sales of the expensive clubs

and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales for the new

project will be:

Sales

New clubs $765  54,000 = $41,310,000

For the variable costs, we must include the units gained or lost from the existing clubs. Note that the

variable costs of the expensive clubs are an inflow. If we are not producing the sets any more, we

will save these variable costs, which is an inflow. So:

Var. costs

New clubs –$473  54,000 = –$25,542,000

The pro forma income statement will be:

Sales $32,190,000

Variable costs 20,193,000

Costs 10,230,000

Using the bottom up OCF calculation, we get:

OCF = NI + Depreciation = –$1,399,800 + 4,100,000

16. To calculate the sensitivity of the NPV to changes in the price of the new club, we need to change the

price of the new club. We will choose $860, but the choice is irrelevant as the sensitivity will be the

same no matter what price we choose.

We will calculate the sales and variable costs first. Since we will lose sales of the expensive clubs

and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales for the new

project will be:

Sales

For the variable costs, we must include the units gained or lost from the existing clubs. Note that the

variable costs of the expensive clubs are an inflow. If we are not producing the sets any more, we

will save these variable costs, which is an inflow. So:

Var. costs

The pro forma income statement will be:

Sales $44,400,000

Variable costs 21,510,000

Fixed costs 9,300,000

Using the bottom up OCF calculation, we get:

OCF = NI + Depreciation = $5,694,000 + 4,100,000

OCF = $9,794,000

And the NPV is:

To calculate the sensitivity of the NPV to changes in the quantity sold of the new club, we need to

We will calculate the sales and variable costs first. Since we will lose sales of the expensive clubs

and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales for the new

project will be:

Sales

For the variable costs, we must include the units gained or lost from the existing clubs. Note that the

variable costs of the expensive clubs are an inflow. If we are not producing the sets any more, we

will save these variable costs, which is an inflow. So:

Var. costs

The pro forma income statement will be:

Sales $48,050,000

Variable costs 23,660,000

Fixed costs 9,300,000

Using the bottom up OCF calculation, we get:

OCF = NI + Depreciation = $6,594,000 + 4,100,000

OCF = $10,694,000

The NPV at this quantity is:

17. a. The base-case NPV is:

b. We would abandon the project if the cash flow from selling the equipment is greater than the

present value of the future cash flows. We need to find the sale quantity where the two are

equal, so:

$820,000 = ($38)Q(PVIFA16%,9)

c. The $820,000 is the market value of the project. If you continue with the project in one year,

18. a. If the project is a success, the present value of the future cash flows will be:

PV future CFs = $38(9,500)(PVIFA16%,9)

PV future CFs = $1,662,962.34

From the previous question, if the quantity sold is 3,800, we would abandon the project, and the

cash flow would be $820,000. Since the project has an equal likelihood of success or failure in

b. If we couldn’t abandon the project, the present value of the future cash flows when the quantity

is 3,800 will be:

The gain from the option to abandon is the abandonment value minus the present value of the

cash flows if we cannot abandon the project, so:

Gain from option to abandon = $820,000 – 665,184.94

19. If the project is a success, the present value of the future cash flows will be:

If the sales are only 3,800 units, from Problem #17, we know we will abandon the project, with a

value of $820,000. Since the project has an equal likelihood of success or failure in one year, the

expected value of the project in one year is the average of the success and failure cash flows, plus the

cash flow in one year, so:

The NPV is the present value of the expected value in one year plus the cost of the equipment, so:

The gain from the option to expand is the present value of the cash flows from the additional units

sold, so:

We need to find the value of the option to expand times the likelihood of expansion. We also need to

find the value of the option to expand today, so:

20. a. The accounting breakeven is the aftertax sum of the fixed costs and depreciation charge divided

by the contribution margin (selling price minus variable cost). In this case, there are no fixed

costs, and the depreciation is the entire price of the press in the first year. So, the accounting

breakeven level of sales is:

b. When calculating the financial breakeven point, we express the initial investment as an

equivalent annual cost (EAC). The initial investment is the $20,000 in licensing fees. Dividing

the initial investment by the three-year annuity factor, discounted at 12 percent, the EAC of the

initial investment is:

Note, this calculation solves for the annuity payment with the initial investment as the present

value of the annuity, in other words:

Now we can calculate the financial breakeven point. Notice that there are no fixed costs or

depreciation. The financial breakeven point for this project is:

21. The payoff from taking the lump sum is $20,000, so we need to compare this to the expected payoff

from taking 1.5 percent of the profit. The decision tree for the movie project is:

Big audience

40% $30,000,000

Movie is

good

Make

The value of 1.5 percent of the profits is as follows. There is a 40 percent probability the movie is

good, and the audience is big, so the expected value of this outcome is:

The value if the movie is good, and has a big audience, assuming the script is good is:

This is the expected value for the studio, but the screenwriter will only receive 1.5 percent of this

amount, so the payment to the screenwriter will be:

22. We can calculate the value of the option to wait as the difference between the NPV of opening the

mine today and the NPV of waiting one year to open the mine. The remaining life of the mine is:

CF = 5,500($1,100) = $6,050,000

So, the NPV of opening the mine today is:

The PV of these cash flows is:

Price increase CF = $7,700,000(PVIFA12%,8) = $38,250,826.20

Price decrease CF = $4,950,000(PVIFA12%,8) = $24,589,816.85

So, the NPV is one year will be:

So, the value of the option to wait is: