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b. Disregard the assumptions in part a. What is Shrieves’ depreciable basis? What
are the annual depreciation expenses?
Answer: The asset’s depreciable basis includes shipping and installation costs. Thus, the asset’s
(Dollars in Thousands)
Year Rate Basis = Depreciation
1 0.3333 $240 $ 80
c. Calculate the annual sales revenues and costs (other than depreciation). Why is it
important to include inflation when estimating cash flows?
Answer: With an inflation rate of 3%, the annual revenues and costs are:
Year 1 Year 2 Year 3 Year 4
Units 1,250 1,250 1,250 1,250
The cost of capital is a nominal cost; i.e., it includes a premium for inflation. In other
words, it is larger than the real cost of capital. Similarly, nominal cash flows (those that
d. Construct annual incremental operating cash flow statements.
Answer:
Year 1
Year 2
Year 3
Year 4
Sales $250,000 $257,500 $265,225 $273,188
Costs 125,000 128,750 132,613 136,588
e. Estimate the required net working capital for each year, and the cash flow due to
investments in net working capital.
Answer: The project requires a level of net working capital in the amount equal to 12% of the
next year’s sales. Any increase in NWC is a negative cash flow, and any decrease is a
Year 0
Year 1
Year 2
Year 3
Year 4
Sales $250,000 $257,500 $265,225 $273,188
f. Calculate the after-tax salvage cash flow.
Answer: When the project is terminated at the end of Year 4, the equipment can be sold for
g. Calculate the net cash flows for each year. Based on these cash flows and the
average project cost of capital, what are the project’s NPV, IRR, MIRR, PI,
payback, and discounted payback? Do these indicators suggest that the project
should be undertaken?
Answer: The net cash flows are:
Year 0
Year 1
Year 2
Year 3
Year 4
Initial Outlay ($240,000
)
)
h. What does the term “risk” mean in the context of capital budgeting; to what
extent can risk be quantified; and when risk is quantified, is the quantification
based primarily on statistical analysis of historical data or on subjective,
judgmental estimates?
Answer: Risk throughout finance relates to uncertainty about future events, and in capital
budgeting, this means the future profitability of a project. For certain types of projects,
it is possible to look back at historical data and to statistically analyze the riskiness of
the investment. This is often true when the investment involves an expansion decision;
i. 1. What are the three types of risk that are relevant in capital budgeting?
2. How is each of these risk types measured, and how do they relate to one another?
Answer: Here are the three types of project risk:
Stand-alone risk is the project’s total risk if it were operated independently.
Stand-alone risk ignores both the firm’s diversification among projects and investors’
Within-firm risk is the total riskiness of the project giving consideration to the firm’s
other projects, that is, to diversification within the firm. It is the contribution of the
Market risk is the riskiness of the project to a well-diversified investor, hence it
i. 3. How is each type of risk used in the capital budgeting process?
Answer: Because management’s primary goal is shareholder wealth maximization, the most
Unfortunately, by far the easiest type of risk to measure is a project’s stand-alone
risk. Thus, firms often focus on this type of risk when making capital budgeting
j. 1. What is sensitivity analysis?
Answer: Sensitivity analysis measures the effect of changes in a particular variable, say
j. 2. Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital
for the project. Assume each of these variables can vary from its base-case, or
expected, value by 10%, 20%, and 30%. Include a sensitivity diagram, and
discuss the results.
Answer: The sensitivity data are given here in tabular form:
Deviation
from
Base Case
NPV Deviation from
Base Case
r
Units
Sold Salvage
-30% $113,270 $16,649 $84,936
We generated these data with a spreadsheet model in the file Ch11 Mini Case Model.xls.
A. The sensitivity lines intersect at 0% change and the base-case NPV, $88,030. Since
B. The plots for unit sales and salvage value are upward sloping, indicating that higher
j. 3. What is the primary weakness of sensitivity analysis? What is its primary
usefulness?
Answer: The two primary disadvantages of sensitivity analysis are (1) that it does not reflect the
effects of diversification and (2) that it does not incorporate any information about the
Therefore, in many situations, sensitivity analysis is not a particularly good risk
k. Assume that Sidney Johnson is confident of her estimates of all the variables that
affect the project’s cash flows except unit sales and sales price. If product
acceptance is poor, unit sales would be only 900 units a year and the unit price
would only be $160; a strong consumer response would produce sales of 1,600
units and a unit price of $240. Sidney believes that there is a 25% chance of poor
acceptance, a 25% chance of excellent acceptance, and a 50% chance of average
acceptance (the base case).
k. 1. What is scenario analysis?
k. 2. What is the worst-case NPV? The best-case NPV?
k. 3. Use the worst-, base-, and best-case NPVs and probabilities of occurrence to find
the project’s expected NPV, standard deviation, and coefficient of variation.
Answer: We used a spreadsheet model to develop the scenarios, which are summarized below:
Scenario Probability Unit Sales Unit Price NPV
Best Case 25% 1,600 $240 $278,940
l. Are there problems with scenario analysis? Define simulation analysis, and discuss
its principal advantages and disadvantages.
Answer: Scenario analysis examines several possible scenarios, usually worst case, most likely
Simulation analysis is a type of scenario analysis that uses randomly generated inputs
rather than specific values. Here the uncertain cash flow variables (such as unit sales)
are entered as continuous probability distribution parameters rather than as point
Although simulation analysis is technically refined, its usefulness is limited because
Recognize also that neither sensitivity, scenario, nor simulation analysis provides a
m. 1. Assume that Shrieves’ average project has a coefficient of variation in the range of
0.2 to 0.4. Would the new line be classified as high risk, average risk, or low risk?
What type of risk is being measured here?
Answer: The project has a CV of 1.15, which is above the average range of 0.2 to 0.4, so it falls
m. 3. Are there any subjective risk factors that should be considered before the final
decision is made?
Answer: A numerical analysis such as this one may not capture all of the risk factors inherent in
the project. If the project has a potential for bringing on harmful lawsuits, then it might
n. What is a real option? What are some types of real options?
Answer: Real options exist when managers can influence the size and risk of a project’s cash
1. Investment timing options
3. Abandonment options
a. Contraction
4. Flexibility options
