The type of option most likely to affect the decision

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Unformatted text preview: ,176,000 0 $1,176,000 Beginning Ending Change Notice that we recover the remaining inventory at the end of the project. The total cash flows for the project will be the sum of the operating cash flow, the capital spending, and the inventory cash flows, so: Year 1 $1,781,400 0 –$84,000 $1,697,400 Year 2 $2,058,600 –16,000,000 –$308,000 –$14,249,400 Year 3 $3,990,200 0 $84,000 $4,074,200 Year 4 $4,365,800 0 $140,000 $4,505,800 Year 5 $3,455,800 7,236,800 $1,176,000 $11,868,600 OCF Equipment Inventory Total The NPV of the project, including the inventory cash flow at the beginning of the project, will be: NPV = –$895,500 + $1,697,400 / 1.14 – $14,249,400 / 1.142 + $4,047,200 / 1.143 + $4,505,800 / 1.144 + $11,868,600 / 1.145 NPV = $1,210,939.96 The company should go ahead with the new table. b. c. You can perform an IRR analysis, and would expect to find three IRRs since the cash flows change signs three times. The profitability index is intended as a “bang for the buck” measure; that is, it shows how much shareholder wealth is created for every dollar of initial investment. This is usually a good measure of the investment since most projects have conventional cash flows. In this case, the largest investment is not at the beginning of the project, but later in its life, so while the interpretation is the same, it really does not measure the bang for the dollar invested. 187 CHAPTER 7 RISK ANALYSIS, REAL OPTIONS, AND CAPITAL BUDGETING Answers to Concepts Review and Critical Thinking Questions 1. 2. 3. Forecasting risk is the risk that a poor decision is made because of errors in projected cash flows. The danger is greatest with a new product because the cash flows are probably harder to predict. With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario analysis, all variables are examined for a limited range of values. It is true that if average revenue is less than average cost, the firm is losing money. This much of the statement is therefore correct. At the margin, however, accepting a project with marginal revenue in excess of its marginal cost clearly acts to increase operating cash flow. From the shareholder perspective, the financial break-even point is the most important. A project can exceed the accounting and cash break-even points but still be below the financial break-even point. This causes a reduction in shareholder (your) wealth. The project will reach the cash break-even first, the accounting break-even next and finally the financial break-even. For a project with an initial investment and sales afterwards, this ordering will always apply. The cash break-even is achieved first since it excludes depreciation. The accounting break-even is next since it includes depreciation. Finally, the financial break-even, which includes the time value of money, is achieved. Traditional NPV analysis is often too conservative because it ignores profitable options such as the ability to expand the project if it is profitable, or abandon the project if it is unprofitable. The option to alter a project when it has already been accepted has a value, which increases the NPV of the project. The type of option most likely to affect the decision is the option to expand. If the country just liberalized its markets, there is likely the potential for growth. First entry into a market, whether an entirely new market, or with a new product, can give a company name recognition and market share. This may make it more difficult for competitors entering the market. Sensitivity analysis can determine how the financial break-even point changes when some factors (such as fixed costs, variable costs, or revenue) change. There are two sources of value with this decision to wait. The price of the timber can potentially increase, and the amount of timber will almost definitely increase, barring a natural catastrophe or forest fire. The option to wait for a logging company is quite valuable, and companies in the industry have models to estimate the future growth of a forest depending on its age. 4. 5. 6. 7. 8. 9. 10. When the additional analysis has a negative NPV. Since the additional analysis is likely to occur almost immediately, this means when the benefits of the additional analysis outweigh the costs. The benefits of the additional analysis are the reduction in the possibility of making a bad decision. Of course, the additional benefits are often difficult, if not impossible, to measure, so much of this decision is based on experience. Solutions to Questions and Problems NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. a. To calculate the accounting breakeven, we first need to find the depreciation for each year. The depreciation is: Depreciation =...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of Texas-Tyler.

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