8/13/15

Chapter: 11 Estimating Cash Flows and Analyzing Risk

Problem: 18

Webmasters.com has developed a powerful new server that would be used for corporations' Internet activities.It would cost $10 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 10% of the year's projected sales; for example, NWC0 = 10%(Sales1).The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit.After Year 1, the sales price and variable costs will increase at the inflation rate of 3%.The company's nonvariable costs would be $1 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 1,000 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 $500,000.Webmasters' federal-plus-state tax rate is 40%.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 a WACC of 8%, and high-risk projects at 13%.

a.Develop a spreadsheet model, and use it to find the project's NPV, IRR, and payback.

Input Data (in thousands of dollars)

Equipmentcost $10,000 Key Results:

Net operating working capital/Sales 10% NPV=

First year sales (in units) 1,000 IRR=

Sales price per unit $24.00 Payback =

Variable cost per unit (excl. depr.) $17.50

Nonvariable costs (excl. depr.) $1,000

Market value of equipment at Year 4 $500

Tax rate 40%

WACC 10%

Inflation in prices and costs 3.0%

Estimated salvage value at year 4 $500

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 $10,000

Annual equipment depr. rate 20.00% 32.00% 19.20% 11.52%

Annual depreciation expense

Ending Bk Val: Cost - Accum Dep'rn $10,000

Salvage value $500

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 (40%)

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 PaybackYears Years

0 1 2 3 4

Net cash flow

Cumulative CF

Part of year requiredfor payback

Data for Discounted PaybackYears Years

0 1 2 3 4

Net cash flow

Discounted cash flow

Cumulative CF

Part of year required for discounted payback

Based on your analysis, what recommendation (accept or reject) would you make about the server project?