Define each of the following terms:
a. Change in net operating working capital
b. Incremental cash flow; sunk cost; opportunity cost; externality; cannibalization effect
c. Replacement analysis
d. Stand-alone risk; corporate (within-firm) risk; market (beta) risk
e. Risk-adjusted cost of capital
f. Sensitivity analysis; base-case NPV
g. Scenario analysis; base-case scenario; worst-case scenario; best-case scenario
h. Monte Carlo simulation
i. Certainty equivalent; risk-adjusted discount rate
ST-2 Project and risk analysis As a financial analyst, you must evaluate a proposed project to
produce printer cartridges. The equipment would cost $55,000, plus $10,000 for installation.
Annual sales would be 4,000 units at a price of $50 per cartridge, and the project’s life
would be 3 years. Current assets would increase by $5,000 and payables by $3,000. At the
end of 3 years the equipment could be sold for $10,000. Depreciation would be based on the
MACRS 3-year class, so the applicable rates would be 33, 45, 15, and 7 percent. Variable
costs would be 70 percent of sales revenues, fixed costs excluding depreciation would be
$30,000 per year, the marginal tax rate is 40 percent, and the corporate WACC is 11 percent.
a. What is the required investment, that is, the Year 0 project cash flow?
b. What are the annual depreciation charges?
c. What is the terminal cash flow?
d. What are the net operating cash flows in Years 1, 2, and 3?
e. What are the annual project cash flows?
f. If the project is of average risk, what is its NPV, and should it be accepted?
g. Suppose management is uncertain about the exact unit sales. What would the
project’s NPV be if unit sales turned out to be 20 percent below forecast, but other
inputs were as forecasted? Would this change the decision?
h. The CFO asks you to do a scenario analysis using these inputs:
Probability Unit Sales VC%
Best case 25% 4,800 65%
Base case 50 4,000 70
Worst case 25 3,200 75
Other variables are unchanged. What are the expected NPV, its standard deviation,
and the coefficient of variation? [Hint: To do the scenario analysis, you must change
unit sales and VC% to the values specified for each scenario, get the scenario cash flows, and then find each scenario’s NPV. Then you must calculate the project’s
expected NPV, standard deviation (SD), and coefficient of variation (CV). This is not
difficult, but it would require a lot of calculations. You might want to look at the
answer, but make sure you understand how it was developed.]
i. The firm’s project CVs generally range from 1.0 to 1.5. A 3 percent risk premium is
added to the WACC if the initial CV exceeds 1.5, and the WACC is reduced by 0.5 per-
cent if the CV is 0.75 or less. Then a revised NPV is calculated. What WACC should be
used for this project? What are the revised values for the NPV, standard deviation,
and coefficient of variation? Would you recommend that the project be accepted?
