Tutorial 1 Solutions Chapter 13

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University of Technology

School of Business Administration


Corporate Finance
Tutorial #1 Capital Budgeting: Other topics Chapter 13 - SOLUTIONs

13-6

Plane A: Expected life = 5 years; Cost = $100 million; NCF = $30 million; COC = 12%. Plane B: Expected life = 10 years; Cost = $132 million; NCF = $25 million; COC = 12%. A: 012% 1 | | -100 30 2 | 30 3 | 30 4 | 30 5 | 30 6 | 30 -100 -70 7 | 30 8 | 30 9 | 30 10 | 30

Enter these values into the cash flow register: CF0 = -100; CF1-4 = 30; CF5 = -70; CF6-10 = 30. Then enter I = 12, and press the NPV key to get NPVA = 12.764 $12.76 million. B: 012% 1 | | -132 25 2 | 25 3 | 25 4 | 25 5 | 25 6 | 25 7 | 25 8 | 25 9 | 25 10 | 25

Enter these cash flows into the cash flow register, along with the interest rate, and press the NPV key to get NPVB = 9.256 $9.26 million. Project A is the better project and will increase the company's value by $12.76 million. 13-7 A: 010% | -10 1 | 4 2 | 4 3 | 4 4 | 4 -6 Machine As simple NPV is calculated as follows: Enter CF0 = -10 and CF1-4 = 4. Then enter I = 10, and press the NPV key to get NPVA = $2.679 million. However, this does not consider the fact that the project can be repeated again. Enter these values into the cash flow register: CF 0 = -10; CF1-3 = 4; CF4 = -6; CF5-8 = 4. Then enter I = 10, and press the NPV key to get Extended NPVA = $4.5096 $4.51 million. 1 5 | 4 6 | 4 7 | 4 8 | 4 -10

B:

010% 1 | | -15 3.5

2 | 3.5

3 | 3.5

4 | 3.5

5 | 3.5

6 | 3.5

7 | 3.5

8 | 3.5

Enter these cash flows into the cash flow register, along with the interest rate, and press the NPV key to get NPV B = $3.672 $3.67 million. Machine A is the better project and will increase the company's value by $4.51 million. 13-8 a. 3 NPV = $2.4083 million. b. Wait 1 year: 0 k = 12% 1 | | 0 -20 Tax |

0 12% |

1 |

2 |

20 | 20 3 3

Tax imposed 25% Prob.

2 | 2.4

3 | 2.4

NPV @ 21 Yr. 0 | 2.4 -$1.8512 | 3.2 | 3.4841

not imposed -20 3.2 3.2

| 3.2

75% Prob.

| 0

Note though, that if the tax is imposed, the NPV of the project is negative and therefore would not be undertaken. The value of this option of waiting one year is evaluated as 0.25($0) + (0.75)($3.4841) = $2.6131 million. Since the NPV of waiting one year is greater than going ahead and proceeding with the project today, it makes sense to wait. 13-9 a. NPV of abandonment after Year t: Using a financial calculator, input the following: CF 0 = -22500, CF1 = 23750, and I = 10 to solve for NPV1 = -$909.09 -$909. Using a financial calculator, input the following: CF 0 = -22500, CF1 = 6250, CF2 = 20250, and I = 10 to solve for NPV 2 = -$82.64 $83. Using a financial calculator, input the following: CF 0 = -22500, CF1 = 6250, Nj = 2, CF3 = 17250, and I = 10 to solve for NPV 3 = $1,307.29 $1,307. Using a financial calculator, input the following: CF 0 = -22500, CF1 = 6250, Nj = 3, CF4 = 11250, and I = 10 to solve for NPV 4 = $726.73 $727. 2

Using a financial calculator, input the following: CF 0 = -22500, CF1 = 6250, Nj = 5, and I = 10 to solve for NPV5 = $1,192.42 $1,192. The firm should operate the truck for 3 years, NPV3 = $1,307. b. No. Abandonment possibilities could only raise NPV and IRR. The value of the firm is maximized by abandoning the project after Year 3.

13-12 a.

0 12% | -6,200,000

1 | 600,000

14 | 600,000

15 | 600,000

Using a financial calculator, input the following data: CF0 = -6,200,000; CF1-15 = 600,000; I = 12; and then solve for NPV = -$2,113,481.31. b. 0 12% | -6,200,000 1 | 1,200,000

14 | 1,200,000

15 | 1,200,000

Using a financial calculator, input the following data: CF0 = -6,200,000; CF1-15 = 1,200,000; I = 12; and then solve for NPV = $1,973,037.39. c. If they proceed with the project today, the projects expected NPV = (0.5 -$2,113,481.31) + (0.5 $1,973,037.39) = -$70,221.96. So, Nevada Enterprises would not do it. d. Since the projects NPV with the tax is negative, if the tax were imposed the firm would abandon the project. Thus, the decision tree looks like this:
0 = 12% 1 k 50% Prob. | | Taxes -6,200,000 6,000,000 No Taxes | 50% Prob. -6,200,000 | 1,200,000 2 | 0 | 1,200,000

15 | 0

NPV @ Yr. 0 -$ 842,857.14

| 1,200,000 1,973,037.39 Expected NPV $ 565,090.13

Yes, the existence of the abandonment option changes the expected NPV of the project from negative to positive. Given this option the firm would take on the project because its expected NPV is $565,090.13. e.
50% Prob. Taxes 0 = 12% 1 k | | NPV = ? -1,500,000 wouldnt do +300,000 = NPV @ t = 1 NPV @ Yr. 0 $ 0.00

No Taxes 50% Prob.

| NPV = ?

| -1,500,000 +4,000,000 = NPV @ t = 1

2,232,142.86 Expected NPV $1,116,071.43

If the firm pays $1,116,071.43 for the option to purchase the land, then the NPV of the project is exactly equal to zero. So the firm would not pay any more than this for the option.

INTEGRATED CASE

21st Century Educational Products Other Topics in Capital Budgeting


13-15 21ST CENTURY EDUCATIONAL PRODUCTS (21ST CENTURY) IS A RAPIDLY GROWING SOFTWARE RELATIVELY COMPANY, LARGE AND CONSISTENT BUDGET. WITH WHILE ITS MOST GROWTH, OF THE IT HAS A CAPITAL COMPANYS

PROJECTS ARE FAIRLY EASY TO EVALUATE, A HANDFUL OF PROJECTS INVOLVE MORE COMPLEX EVALUATIONS. JOHN KELLER, THE A SENIOR MEMBER OF OF THE MORE COMPANYS COMPLEX FINANCE PROJECTS. STAFF, HIS COORDINATES EVALUATION THESE

GROUP BRINGS THEIR RECOMMENDATIONS DIRECTLY TO THE COMPANYS CFO AND CEO, KRISTIN RILEY AND BOB STEVENS, RESPECTIVELY. A. RIGHT NOW, KELLERS GROUP IS LOOKING AT A VARIETY OF INTERESTING

PROJECTS.

FOR EXAMPLE, THE GROUP HAS BEEN ASKED TO CHOOSE BETWEEN

THE FOLLOWING TWO MUTUALLY EXCLUSIVE PROJECTS: EXPECTED NET CASH FLOWS PROJECT S PROJECT L ($100,000) ($100,000) 59,000 33,500 59,000 33,500 -33,500 -33,500

YEAR 0 1 2 3 4

BOTH PROJECTS MAY BE REPEATED AND BOTH ARE OF AVERAGE RISK, SO THEY SHOULD BE EVALUATED AT THE FIRM'S COST OF CAPITAL, 10 PERCENT. WHICH ONE SHOULD BE CHOSEN? ANSWER: [SHOW S13-1 THROUGH S13-5 HERE.] PROJECT S: 0 10% | -100,000 1 | 59,000 2 | 59,000 -100,000 -41,000 3 | 59,000 4 | 59,000

USING A FINANCIAL CALCULATOR, INPUT THE FOLLOWING DATA: SOLVE FOR NPV = $4,377.43. PROJECT L: 0 10% | -100,000 1 | 33,500 2 | 33,500 3 | 33,500

CF0 =

-100,000; CF1 = 59,000; CF2 = -41,000; CF3-4 = 59,000; I = 10; AND THEN

4 | 33,500 CF0 =

USING A FINANCIAL CALCULATOR, INPUT THE FOLLOWING DATA:

-100,000; CF1-4 = 33,500; I = 10; AND THEN SOLVE FOR NPV = $6,190.49. PROJECT L SHOULD BE CHOSEN SINCE IT HAS A HIGHER NPV THAN PROJECT S.

B.

IN RECENT MONTHS, KELLERS GROUP HAS BEGUN TO FOCUS ON REAL OPTION ANALYSIS. 1. WHAT IS REAL OPTION ANALYSIS?

ANSWER:

[SHOW S13-6 HERE.]

REAL OPTIONS EXIST WHEN MANAGERS CAN INFLUENCE

THE SIZE AND RISKINESS OF A PROJECTS CASH FLOWS BY TAKING DIFFERENT ACTIONS DURING OR AT THE END OF A PROJECTS LIFE. REAL OPTION ANALYSIS INCLUDES IN THE TYPICAL NPV CAPITAL BUDGETING ANALYSIS AN ANALYSIS FOR OPPORTUNITIES FOR MANAGERS TO RESPOND TO CHANGING CIRCUMSTANCES BECAUSE MANAGEMENTS ACTIONS CAN INFLUENCE A PROJECTS OUTCOME.

B.

2. WHAT ARE SOME EXAMPLES OF PROJECTS WITH EMBEDDED REAL OPTIONS? [SHOW S13-7 HERE.] TYPES OF EMBEDDED A PROJECT MAY CONTAIN ONE OR MORE DIFFERENT REAL OPTIONS. EXAMPLES INCLUDE ABANDON-

ANSWER:

MENT/SHUTDOWN OPTIONS, INVESTMENT TIMING OPTIONS, GROWTH/EXPANSION OPTIONS, AND FLEXIBILITY OPTIONS.

C.

TAKING REAL OPTIONS INTO ACCOUNT, ONE OF KELLERS COLLEAGUES, BARBARA HUDSON, HAS SUGGESTED THAT INSTEAD OF INVESTING IN PROJECT L TODAY, IT MIGHT MAKE SENSE TO WAIT A YEAR BECAUSE 21ST CENTURY WOULD LEARN A LOT MORE ABOUT MARKET CONDITIONS AND WOULD BE BETTER ABLE TO FORECAST THE PROJECT'S CASH FLOWS. RIGHT NOW, 21ST CENTURY

FORECASTS

THAT

PROJECT

WILL

GENERATE

EXPECTED

YEARLY

NET

CASH

FLOWS OF $33,500.

HOWEVER, IF THE COMPANY WAITS A YEAR, IT WILL THERE IS A 50 PERCENT CHANCE THE TO YEARLY WAIT A CASH FLOWS THE WILL BE

LEARN MORE ABOUT MARKET CONDITIONS. WEAK. $43,500. $23,500. IF THE IF MARKET 21ST IS STRONG, CHOOSES

THAT THE MARKET WILL BE STRONG AND A 50 PERCENT CHANCE IT WILL BE IF THE MARKET IS WEAK, THE YEARLY CASH FLOWS WILL BE ONLY CENTURY YEAR, INITIAL ASSUME THAT ALL CASH FLOWS ARE

INVESTMENT WILL REMAIN $100,000. DISCOUNTED AT 10 PERCENT. THE PROJECT? ANSWER: [SHOW S13-8 THROUGH S13-11 HERE.] 50% PROB. 0 = 10% 1 k STRONG MKT. | | 0 -100,000 WEAK MKT. 50% PROB. | 0 | -100,000 2 | 43,500 | 23,500

SHOULD 21ST CENTURY INVEST IN PROJECT L

TODAY, OR SHOULD IT WAIT A YEAR BEFORE DECIDING WHETHER TO INVEST IN

3 | 43,500 | 23,500

4 | 43,500 | 23,500

5 | 43,500 | 23,500

NPV @ t = 1 $37,889.15 -25,508.16

HOWEVER, IN A WEAK MARKET THE FIRM WILL NOT UNDERTAKE PROJECT L SINCE ITS NPV < 0. CONSEQUENTLY, THE EXPECTED NPV OF WAITING ONE HOWEVER, THIS IS SO, THE VALUE = $17,222.34. YEAR IS (0.5)$0 + (0.5)($37,889.15) = $18,944.58. FIND THE VALUE TODAY OF WAITING TO DO PROJECT L. TODAY OF WAITING IS CALCULATED AS $18,944.58/1.10

THE PRESENT VALUE AT YEAR 1, SO MUST DISCOUNT IT BACK ONE YEAR TO

THEREFORE, THE FIRM SHOULD WAIT TO GET MORE INFORMATION ABOUT THE MARKET RATHER THAN UNDERTAKING PROJECT L TODAY BECAUSE THE NPV IS $17,222.34 COMPARED TO $6,190.49, THE NPV OF DOING IT TODAY.

D.

NOW LETS ASSUME THAT THERE IS MORE UNCERTAINTY ABOUT THE FUTURE CASH FLOWS. MORE SPECIFICALLY, ASSUME THAT THE YEARLY CASH FLOWS ARE NOW $53,500 IF THE MARKET IS STRONG AND $13,500 IF THE MARKET IS WEAK. ASSUME THAT THE UP-FRONT COST IS STILL $100,000 AND THAT THE COST OF CAPITAL IS STILL 10 PERCENT. WILL THIS INCREASED UNCERTAINTY MAKE THE FIRM MORE OR LESS WILLING TO INVEST IN THE PROJECT TODAY?

ANSWER:

[SHOW S13-12 AND S13-13 HERE.] 50% PROB. 0 = 10% 1 k STRONG MKT. | | 0 -100,000 WEAK MKT. 50% PROB. | 0 | -100,000 2 | 53,500 | 13,500 3 | 53,500 | 13,500 4 | 53,500 | 13,500 5 | 53,500 | 13,500 NPV @ t = 1 $69,587.80 -57,206.82

IN A WEAK MARKET THE FIRM WILL NOT UNDERTAKE PROJECT L SINCE ITS NPV < 0. + CONSEQUENTLY, THE EXPECTED NPV OF WAITING ONE YEAR IS (0.5)$0 = $34,793.90. HOWEVER, THIS IS THE PRESENT (0.5)($69,587.80)

VALUE AT YEAR 1, SO WE MUST DISCOUNT IT BACK ONE YEAR TO FIND THE VALUE TODAY OF WAITING TO DO PROJECT L. SO, THE VALUE TODAY OF THEREFORE, $31,630.82 WAITING IS CALCULATED AS $34,793.90/1.10 = $31,630.82. THAN UNDERTAKING PROJECT L TODAY BECAUSE THE NPV IS

THE FIRM SHOULD WAIT TO GET MORE INFORMATION ABOUT THE MARKET RATHER COMPARED TO $6,190.49, THE NPV OF DOING IT TODAY. THE MORE VARIABLE THE CASH FLOWS (THE MORE UNCERTAINTY) THE LESS WILLING THE FIRM WILL BE TO INVEST IN THE PROJECT TODAY. FACTORS THE FIRM SHOULD CONSIDER WHEN DECIDING WHEN TO INVEST: 1. DELAYING THE PROJECT MEANS THAT CASH FLOWS COME LATER RATHER THAN SOONER. 2. IT MIGHT MAKE SENSE TO PROCEED TODAY IF THERE ARE IMPORTANT

ADVANTAGES TO BEING THE FIRST COMPETITOR TO ENTER A MARKET. 3. WAITING MAY ALLOW YOU TO TAKE ADVANTAGE OF CHANGING CONDITIONS.

E.

21ST CENTURY IS CONSIDERING ANOTHER PROJECT, PROJECT Y.

PROJECT Y HAS

AN UP-FRONT COST OF $200,000 AND AN ECONOMIC LIFE OF THREE YEARS. IF THE COMPANY DEVELOPS THE PROJECT, ITS AFTER-TAX OPERATING COSTS WILL BE $100,000 A YEAR; HOWEVER, THE PROJECT IS EXPECTED TO PRODUCE AFTER-TAX CASH INFLOWS OF $180,000 A YEAR. ESTIMATED CASH FLOWS ARE AS FOLLOWS: YEAR 0 1 2 3 CASH OUTFLOWS -$200,000 -100,000 -100,000 -100,000 CASH INFLOWS $ 0 180,000 180,000 180,000 NET CASH FLOWS -$200,000 80,000 80,000 80,000 THUS, THE PROJECTS

1. THE PROJECT HAS AN ESTIMATED COST OF CAPITAL OF 10 PERCENT. THE PROJECTS NPV? ANSWER: [SHOW S13-14 HERE.] 10% 1 | 80,000 2 | 80,000 3 | 80,000

WHAT IS

0 | -200,000

USING A FINANCIAL CALCULATOR, INPUT THE FOLLOWING DATA:

CF0 =

-200,000; CF1-3 = 80,000; I = 10; AND THEN SOLVE FOR NPV = -$1,051.84.

E.

2. WHILE THE PROJECTS OPERATING COSTS ARE FAIRLY CERTAIN AT $100,000 PER YEAR, THE ESTIMATED CASH INFLOWS DEPEND CRITICALLY ON WHETHER 21ST CENTURY'S LARGEST CUSTOMER USES THE PRODUCT. KELLER ESTIMATES THAT THERE IS A 60 PERCENT CHANCE THE CUSTOMER WILL USE THE PRODUCT, IN WHICH CASE THE PROJECT WILL PRODUCE AFTER-TAX CASH INFLOWS OF $250,000. PRODUCT, INFLOWS -$25,000. IN OF THUS, ITS NET CASH FLOWS WOULD BE $150,000 PER YEAR. WHICH ONLY CASE THE PROJECT THUS, ITS WILL NET PRODUCE CASH AFTER-TAX WOULD CASH BE HOWEVER, THERE IS A 40 PERCENT CHANCE THE CUSTOMER WILL NOT USE THE $75,000. FLOWS

WRITE OUT THE ESTIMATED CASH FLOWS, AND CALCULATE THE

PROJECTS NPV UNDER EACH OF THE TWO SCENARIOS. ANSWER: [SHOW S13-15 AND S13-16 HERE.] CUSTOMER USES PRODUCT (60% PROBABILITY) 0 10% | -200,000 1 | 150,000 2 | 150,000 3 | 150,000 CF0 = NPV =

USING A FINANCIAL CALCULATOR, INPUT THE FOLLOWING DATA: -200,000; CF1-3 = 150,000; I = 10; AND THEN SOLVE FOR $173,027.80. CUSTOMER DOESNT USE PRODUCT (40% PROBABILITY) 0 10% | -200,000 1 | -25,000 2 | -25,000 3 | -25,000

USING A FINANCIAL CALCULATOR, INPUT THE FOLLOWING DATA: -200,000; CF1-3 = -25,000; I = 10; AND THEN SOLVE FOR -$262,171.30.

CF0 = NPV =

E.

3. WHILE 21ST CENTURY DOES NOT HAVE THE OPTION TO DELAY THE PROJECT, IT WILL KNOW ONE YEAR FROM NOW IF THE KEY CUSTOMER HAS SELECTED THE PRODUCT. IF THE CUSTOMER CHOOSES NOT TO ADOPT THE PRODUCT, 21ST IF IT ABANDONS THE THUS, IF THE CENTURY HAS THE OPTION TO ABANDON THE PROJECT.

PROJECT, IT WILL NOT RECEIVE ANY CASH FLOWS AFTER YEAR 1, AND IT WILL NOT INCUR ANY OPERATING COSTS AFTER YEAR 1. AS FOLLOWS: 0 | -200,000 | -200,000 A COST 1 | 150,000 | -25,000 OF CAPITAL OF 10 PERCENT, WHAT IS THE 2 | 150,000 3 | 150,000 COMPANY CHOOSES TO ABANDON THE PROJECT, ITS ESTIMATED CASH FLOWS ARE

60% PROB. 40% PROB. AGAIN,

ASSUMING

PROJECTS EXPECTED NPV IF IT ABANDONS THE PROJECT? ABANDON THE PROJECT AT t = 1? ANSWER: [SHOW S13-17 AND S13-18 HERE.] 0k = 10% 1 | | 60% PROB. -200,000 150,000 | 40% PROB. -200,000 | -25,000 2 | 150,000 3 | 150,000

SHOULD 21ST

CENTURY INVEST IN PROJECT Y TODAY, REALIZING IT HAS THE OPTION TO

NPV @ t = 0 $173,027.80 -222,727.27

E(NPV) = 0.6($173,027.80) + 0.4(-$222,727.27) = $14,725.77. E. 4. UP UNTIL NOW WE HAVE ASSUMED THAT THE ABANDONMENT OPTION HAS NOT AFFECTED CAPITAL? THE PROJECTS COST OF CAPITAL. IS THIS ASSUMPTION REASONABLE? HOW MIGHT THE ABANDONMENT OPTION AFFECT THE COST OF

ANSWER:

[SHOW

S13-19

HERE.]

IT

IS

NOT

REASONABLE

TO

ASSUME

THAT

THE

ABANDONMENT OPTION HAS NO EFFECT ON THE COST OF CAPITAL. COST OF CAPITAL.

HAVING THE

ABILITY TO ABANDON A PROJECT REDUCES RISK; THEREFORE, REDUCING ITS

F.

FINALLY, 21ST CENTURY IS ALSO CONSIDERING PROJECT Z.

PROJECT Z HAS AN

UP-FRONT COST OF $500,000, AND IT IS EXPECTED TO PRODUCE AFTER-TAX CASH INFLOWS OF $100,000 AT THE END OF EACH OF THE NEXT FIVE YEARS (t = 1, 2, 3, 4, AND 5). GROUP TODAY, RECOGNIZE THERE IS THAT A IF 10 BECAUSE PROJECT Z HAS A COST OF CAPITAL OF HOWEVER, KELLER AND HIS AHEAD THIS WITH WILL PROJECT LEAD Z TO 21ST CENTURY CHANCE GOES 12 PERCENT, IT CLEARLY HAS A NEGATIVE NPV. PERCENT

THAT

SUBSEQUENT OPPORTUNITIES THAT HAVE A NET PRESENT VALUE AT t = 5 EQUAL TO $3,000,000. AT THE SAME TIME, THERE IS A 90 PERCENT CHANCE ON THE BASIS OF THEIR KNOWLEDGE OF THAT THE SUBSEQUENT OPPORTUNITIES WILL HAVE A NEGATIVE NET PRESENT VALUE (-$1,000,000) AT t = 5. REAL OPTIONS, KELLER AND HIS GROUP UNDERSTAND THAT THE COMPANY WILL CHOOSE TO DEVELOP THESE SUBSEQUENT OPPORTUNITIES ONLY IF THEY APPEAR TO BE PROFITABLE AT t = 5. GIVEN THIS INFORMATION, SHOULD 21ST CENTURY INVEST IN PROJECT Z TODAY? ANSWER: [SHOW S13-20 THROUGH S13-24 HERE.]
10% PROB. 0 = 12% 1 k | | -500,000 100,000 2 | 100,000 3 | 100,000 4 | 100,000 5 | 100,000 3,000,000 3,100,000 | | 100,000 100,000 -1,000,000 NPV @ t = 0 $1,562,758.19

90% | PROB.-500,000

| 100,000

| 100,000

| 100,000

-139,522.38 WILL NOT DO

IF IT TURNS OUT THAT THE PROJECT AT YEAR 5 HAS A NEGATIVE NPV OF FUTURE OPPORTUNITIES, THE FIRM WILL NOT PURSUE THEM. $500,000 OUTLAY AND THE $100,000 INFLOWS. $30,705.68. THEREFORE, THE CASH FLOWS FOR THAT BRANCH OF THE DECISION TREE INCLUDE ONLY THE THEREFORE, THE EXPECTED NPV OF PROJECT Z IS (0.10)($1,562,758.19) + (0.9)(-$139,522.38) = THEREFORE, PROJECT Z HAS A POSITIVE NPV SO THE FIRM SHOULD INVEST IN IT TODAY.

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