Managerial Finance Question

Start with the partial model in the attached.

Pinto.com has developed a powerful new server that would be used for corporations’ Internet activities. It would cost $25 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 12% of the year’s projected sales; for example, NWC0 = 12%(Sales1 ). The servers would sell for $21,000 per unit, and Pinto believes that variable costs would amount to $15,000 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 2.5%. The company’s nonvariable costs would be $1.5 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 2,000 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 $1 million. Pinto.com’s federal-plus-state tax rate is 20%. 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 an 8% project cost of capital and high-risk projects at 13%.

1. Develop a spreadsheet model, and use it to find the project’s NPV, IRR, and payback.
2. 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.
3. 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.
4. If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and payback.
5. On the basis of information in the problem, would you recommend the project should be accepted?

Build a Model

Chapter:	11	Cash Flow Estimation and Risk Analysis
a. Develop a spreadsheet model, and use it to find the project’s NPV, IRR, and payback.
Input Data (in thousands of dollars)
Scenario name	Base Case	Note: the items in red will be used in a scenario analysis.
Probability of scenario	50%
Equipment cost	$25,000
Net operating working capital/Sales	12%	Key Results:
First year sales (in units)	2,000	NPV =
Sales price per unit	$21.00	IRR =
Variable cost per unit (excl. depr.)	$15.00	Payback =
Nonvariable costs (excl. depr.)	$1,500
Inflation in prices and costs	2.5%
Estimated salvage value at year 4	$1,000
Depreciation years	Year 1	Year 2	Year 3	Year 4
Depreciation rates	20.00%	32.00%	19.20%	11.52%
Tax rate	20%
WACC for average-risk projects	10%
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
Annual equipment depr. rate	20.00%	32.00%	19.20%	11.52%
Annual depreciation expense
Ending Bk Val: Cost – Accum Dep’rn
Salvage value
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 (20%)
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	$0	$0	$0	$0	$0
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.
% Deviation	1st YEAR UNIT SALES	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 1st Year Unit Sales in Cell B79 should be the number 2,000 and NOT have the formula =D10 in that cell. This is because you’ll use D10 as the column input cell in the data table and if Excel tries to iteratively replace Cell D10 with the formula =D10 rather than a series of numbers, 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!
from	Base	NPV
Base Case	2,000	$0
-20%
-10%
0%
10%
20%
% Deviation	SALES PRICE	% Deviation	VARIABLE COST
from	Base	NPV	from	Base	NPV
Base Case	$21.00	$0	Base Case	$15.00	$0
-20%	-20%
-10%	-10%
0%	0%
10%	10%
20%	20%
Deviation	NPV at Different Deviations from Base
from	Sales	Variable
Base Case	Units Sold	Price	Cost/Unit
-20%	$0	$0	$0
-10%	$0	$0	$0
0%	$0	$0	$0
10%	$0	$0	$0
20%	$0	$0	$0
Range	$0	$0	$0
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. (Hint: Use Scenario Manager. Go to the Data menu, choose What-If-Analyis, the choose Scenario Manager. After you create the Scenario’s, you can pick a scenario and type in the resulting NPV (but be sure to return the Scenario to the base-case afterward). Or you can create a Scenario Summary and use a cell reference to the Scenario Summary worksheet to show the NPV for each scenario.)
Unit Sales	Sales Price per Unit	Variable Costs per Unit
Scenario	Probability	NPV
Best Case	25%	2,400	$24.00	$12.00
Base Case	50%	2,000	$20.00	$15.00
Worst Case	25%	1,600	$16.00	$18.00
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?

 

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