Chapter 5: Risk Analysis in Capital Budgeting

Shapiro: CHAPTER 5 QUESTIONS

1. Comment on the following statements: a. Because our new expansion pro ect has the same systematic risk as the firm as a whole! we need do no further risk analysis on the pro ect." Answer: #n$estors holding the firm%s stock in their portfolios will consider the systematic risk calculation most important. &owe$er! analysis and simulation may re$eal risks hidden 'y the systematic risk calculation. (or example! if a pro ect might dri$e a firm into 'ankruptcy! shareholders would ha$e to 'ear deadweight 'ankruptcy losses and the costs of financial distress in general. '. )ur company should accept the new potash mine pro ect at *oose aw. +he cost of additional loans to fund the pro ect is 1, percent! and our simulations lead us to expect a 1- percent return from the pro ect." Answer: .hile the company expects a 1-/ return on assets! this calculation fails to determine the re0uired discount rate for cash flows. (urthermore! the cost of de't is not necessarily e0ual to the pro ect cost of capital. )ne needs to know what it would cost to finance the pro ect on a stand1alone 'asis. +he 1,/ cost of de't financing is 'ased on the riskiness of the company%s assets that 'ack the de't! not the riskiness of the pro ect itself. c. #t is difficult to decide whether to spend 213 million to reopen our mine 'ecause the price of gold is so uncertain. &owe$er! if we assume the price of gold grows at an a$erage of 5 percent a year with a standard de$iation of ,3 percent a year! simulation indicates the mine has an a$erage 456 of 2533!333. +herefore! we should reopen." Answer: 7xpected net present $alue was calculated in the a'sence of a risk ad ustment. (or a risk1neutral profit maximi8ing firm! the decision is appropriate. 9ince the shareholders of most firms are not risk1neutral! a discount rate different than the risk1free rate must 'e used. ,. Assess the impact of the following e$ents on a firm%s operating le$erage: a. an increase in output price due to increased demand. '. a decrease in fixed cost. c. negotiation of a new contract with suppliers leading to higher commitments to purchase raw materials. d. lowered $aria'le la'or costs per unit of output. e. installation of new machine tools that lower $aria'le production costs per unit of output. Answer: #n general! factors that increase the le$el of fixed costs within a firm also increase its operating le$erage. +herefore! e$ent :'; reduces operating le$erage while e$ent :c; increases operating le$erage. +he opposite effect pre$ails for $aria'le costs. 7$ents :a; and :d; increase the contri'ution margin! and therefore reduce operating le$erage. 7$ent :e; affects 'oth fixed and $aria'le costs< the dominant effect is uncertain. =. Consider two firms! one American and the other >apanese! using identical production processes< that is! they use the same e0uipment and hire the same num'er of workers. &owe$er! the >apanese firm follows a no1layoff policy! whereas the American firm is willing to alter its work force in line with changing market conditions. .hich company will ha$e the larger amount of operating le$erage? .hy? &ow will the difference in amounts of operating le$erage affect their marketing and production decisions and strategies?

Chapter 5: Risk Analysis in Capital Budgeting Answer: +he >apanese firm will ha$e greater operating le$erage. (or their firm! la'or is considered a fixed cost. #ncreased fixed costs increase operating le$erage. +he American firm has the option to ad ust the le$el of la'or according to changes in market conditions. +his option comes at a cost. .ith a lower marginal cost of production! the >apanese firm will continue to produce when the Americans lose money in production. 9ince their marginal cost is lower! they will sell at a lower price and seek to aggressi$ely capture market share< they will continue to produce as long as marginal re$enue exceeds marginal costs! regardless of their o$erall profita'ility. +he >apanese firm will emphasi8e sales growth since for them! with a low marginal cost of production! re$enue and profit are $irtually identical. -. +he CA5* and the A5+ argue that only systematic risk matters< risk that is di$ersifia'le is irrele$ant to the well1di$ersified in$estor. @et this chapter has argued that total risk matters! not ust systematic risk. #s there an inconsistency here? 7xplain. Answer: +here is no inconsistency. +he CA5* and A5+ argue that only systematic risk matters in determining the appropriate rates to 'e used to discount future cash flows. +hey do not demonstrate the effect of systematic and non1systematic risks on the cash flows themsel$es. +his chapter makes the argument that total risk may affect the le$el of future cash flows! and thus is an appropriate risk consideration in capital 'udgeting. 5. .hat is the ad$antage of using certainty1e0ui$alent cash flows instead of risk1ad usted discount rates to calculate the 456 of an in$estment pro ect? Answer: Certainty e0ui$alents are minimum fixed cash payments that would 'e accepted in lieu of risky cash flows< the decision maker is indifferent 'etween a risky gam'le and a particular fixed payoff. 7ach risky cash flow may 'e ad usted indi$idually. Certain cash flows can 'e discounted at the risk1free rate. +he present $alue thus deri$ed is e0ui$alent to the one deri$ed from expected cash flows and risk1ad usted discount rates.

PROBLEMS
1. 9uppose that Bethlehem 9teel has a current sales le$el of 2,.5 'illion! $aria'le costs of 2, 'illion! and fixed costs of 2-33 million. #f sales rise 'y 15 percent! how much will pre1tax profit increase in dollar terms? .hat will 'e the percentage increase in pre1tax profit? .hat explains the relationship 'etween the percentage change in sales and the percentage change in pre1tax profit for Bethlehem? Answer: Currently! pretax profit A 2,.5B B ,B B 3.-B A 23.1B. .e assume that $aria'le costs are proportional to sales. 9ales in the new year are ,.5:1.15; A 2,.CD5B. Costs are ,.3:1.15; A 2,.=B. 9o! pretax profit A ,.CD5 B ,.= B 3.- A 23.1D5B! a D5/ increase. +his pro'lem demonstrates the potential effects of operating le$erage. ,. #n early 1EE3! Boeing Co. decided to gam'le 2- 'illion to 'uild a new long1distance! =531seat wide1'ody airplane called the Boeing DDD. +he price tag for the DDD! scheduled for deli$ery 'eginning in 1EE5! is a'out 21,3 million apiece. Assume that Boeing%s 2- 'illion in$estment is made at the rate of 2C33 million a year for the years 1EE3 through 1EE- and that the present $alue of the tax write1off associated with these costs is 2D53 million. Based on estimated annual fixed costs of 2133 million! $aria'le production costs of 2E3 million apiece! a marginal corporate tax rate of =- percent and a discount rate of 1- percent! what is the 'reak1e$en 0uantity of annual unit sales o$er the Boeing DDD%s pro ected 151year life? Assume that all cash inflows and outflows occur at the end of the year.

Chapter 5: Risk Analysis in Capital Budgeting Answer: =. +he recently opened Frand &yatt .ailea Resort and 9pa on *aui cost 2G33 million! a'out 2C33!333 per room! to 'uild. Haily operating expenses a$erage 21=5 a room if occupied and 2C3 a room if unoccupied :much of the la'or cost of running a hotel is fixed;. At an a$erage room rate of 2533 a night! a marginal tax rate of -3 percent! and a cost of capital of 11 percent! what year1round occupancy rate do the >apanese in$estors who financed the Frand &yatt .ailea re0uire to 'reak e$en in economic terms on their in$estment o$er its estimated -31year life? .hat is the likelihood that this in$estment will ha$e a positi$e 456? Assume that the 2-53 million expense of 'uilding the hotel can 'e written off straight line o$er a =31year period :the other 2153 million is for the land which is not deprecia'le; and that the present $alue of the hotel%s terminal $alue will 'e 2,33 million. Answer: -. Conduct a sensiti$ity analysis for a pro ect with the following characteristics. 7ach parameter can take on any of three different $alues 'ut once a parameter $alue is selected! that $alue remains constant for the ten1year period. +he discount rate is 13 percent and the pro ect life is ten years. #gnore taxes and depreciation.
Low (1) Sales (units) (2) Price (per unit) (3) Variable cost (per unit) (4) Fixe cost (!) "nitial in#est$ent 1%& '3(&&& 3(&&& 1&&(&&& 1(&&&(&&& Mean !&& '3()!& 3(&&& 2&&(&&& 2(&&&(&&& High *%& '4(&&& 3(&&& 4(&&& 4(&&&(&&&

Answer: +he pro'lem implies that since 56#(A A G.--D! the discount rate is C.E/ per year. (or the mean case!

E[NPV] = 2,000,000 + 6.447{ 500 (3750 3000) 200,000 }

A 2CD1!DD5 9ensiti$ity Analysis allows each $aria'le indi$idually to de$iate from its mean $alue: :e.g. ,!515!DG3 A ,!333!333 I G.--DJ1G3:=D53 =333; ,33!333K
Variable Sales Price Variable ,osts Fixe ,osts Low High '2(!1!()%& '1(3!2(44& '3(2+*(4&& '%!(*&& '+)1())! '+)1())! '22)(&)! '2(1%1(1)!

5. American (ruit Co. is considering constructing a new plant to process fro8en fruit uices. )ne plant would 'e capital intensi$e! the other much more la'or intensi$e. Although the final decision would hinge on the relati$e cost of capital $ersus la'or in the northern California area! management is curious a'out the 'eha$ior of the plants% return on assets during a typical 'usiness cycle. a. Fi$en the following information! calculate the 'reak1e$en point in units of production for the two plants.

Chapter 5: Risk Analysis in Capital Budgeting Answer: L1 A (M:5 B 6; A ,33!333M:, B 1.53; A -33!333 units L, A (M:5 B 6; A G33!333M:, B 3.53; A -33!333 units '. +he economics department has prepared sales pro ections for three 'usiness scenarios: recession! normal! and reco$ery. 9ales under each scenario are expected to 'e as follows: recession! =33!333 units< normal! 533!333 units< and reco$ery! C33!333 units. Calculate the return on assets for the two plants under these three scenarios. Answer: R)A A ReturnM#n$estment< for 5lant 1 :Recession;: Return A =33!333:, B 1.5; B ,33!333 A B53!333 R)A A B53!333M1!333!333 A B5/

Chapter 5: Risk Analysis in Capital Budgeting

Chapter 5: Risk Analysis in Capital Budgeting

Chapter 5: Risk Analysis in Capital Budgeting

c. #f the three scenarios are all e0ually likely! what will 'e the $ariance of the return on assets for plant 1? (or plant ,? .hat would you ad$ise American (ruit?
Plant 1 Fixe cost Variable cost (per unit) Price (per unit) "n#est$ent '2&&(&&& 1-!& 2-&& 1(&&&(&&& Plant 2 '%&&(&&& -!& 2-&& 1(&&&(&&&

5lant , has higher expected returns! 'ut these returns 'ear more systematic risk than those of 5lant 1. Also! 5lant , is operationally more le$ered than plant 1. +he manager needs to assess the contri'ution to portfolio risk of each of the pro ects! and to consider the risks of operating le$erage in his decision. #n particular! it seems that the portfolio risk and the total risk of plant , are greater< the additional expected return may or may not 'e enough to compensate the firm for 'earing this risk. G. (or the following pro ect! the chief financial officer has prepared a set of certainty1e0ui$alent factors to ad ust the cash flows for the estimated risk. +he economics department has also prepared a set of risk1ad usted interest rates at which to discount the pro ect%s cash flow. +he pro ect%s initial in$estment is 2153!333 and the +reasury security rate is C percent
.ear ,ash /lows ('&&&) ,ertaint0 e1ui#alents (/inance epart$ent) 2is34a 5uste rates (econo$ics epart$ent) 1 '!& -*+2 1&6 2 ')! -*%4 126 3 '13& -*4) 146

a. .hat is the 456 of the pro ect from the finance department%s estimates?
Answer7 ,81(&&&9s) : !&(&-*+2) : 4*-1 ;<<<<<<<<<<<<<<<<<<<<<<<<<<<= ,82 : )!(&-*%4) : )2-3 >PV : <,& ? S ,8t@(1 ? r/)t ,83 : 13&(&-*4)) : 123-1 A<<<<<<<<<<<<<<<<<<<<<<<<<<<B

NPV(000s) = 150 + 4 .1!1.0" + 72.3 !1.0"2 + 123.11!1.0"3

A 255!1DD. '. .hat is the 456 from the economics department%s estimates? Answer: 56:333%s; A 53M1.13 I D5M:1.1,;, I 1=3M:1.1-;= A 2-,!EE, c. .hat would you ad$ise the company to do? Answer: Accept the pro ect 'ecause it has positi$e net present $alue. +he finance department method :C7L; may 'e more relia'le if risk and time $alue are measured consistently and separately.

Chapter 5: Risk Analysis in Capital Budgeting D. A gold mine is considering replacement of some machinery. +he new con$eyor 'elt will cost 25 million and lower the cost of remo$ing ore from the mine 'y 2- per ton. +he old 'elt can 'e scrapped for 2533!333. +he following ta'le shows that the life of the new machine is uncertain! as is the annual amount of ore that will 'e mo$ed:
Low Cons per 0ear Li/e o/ new $achine 2&&(&&& % 0ears Mean 2!&(&&& * 0ears High 3!&(&&& 13 0ears

Conduct a sensiti$ity analysis of the 456 of the replacement pro ect assuming a discount rate of 13 percent. #gnore taxes. Answer: +he analysis $aries indi$idual components while all others are $alued at their means. 456 A B-!533!333 I - N :4um'er of tons; N :56#(A factor; 456:mean; A B-!533!333 I -:,53!333;:5.D5E; A 1!,5E!333
Low Mean High >PV(Low) >PV(High) Con 2&&(&&& 2!&(&&& 3!&(&&& '1&)(2&& '3(!%2(%&& Li/e % * 13 <14!(&&& 2(%&3(&&& PV"FD(1&6) 4-3!! !-)!* )-1&3

C. +eletech Co. wants to use a decision tree in e$aluating a $enture capital in$estment in ca'le +6. +he pro ected in$estment has a life of three years! and the associated after1tax cash flows :2333; and pro'a'ilities are as follows:
.ear 1 ,ash /low7 '1&& P : -!& '2&& P : -!& .ear 2 "/ cash /low in 0ear 1 : '1&& .ear 2 cash /low : '12& P : -%& : '* P : -4& "/ cash /low in 0ear 1 : '2&& .ear 2 cash /low : '2!& P : -!& : '21& P : -!&

Year 3

<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< <<<<<<<<<

#f cash flow in year , A 21,3! can sell the in$estment for either 2=53 :5 A .D3; or 2,53. #f cash flow in year , A 2E5! can sell the in$estment for either 21,5 :5 A .G3; or 2D5. #f cash flow in year , A 2,53! can sell the in$estment for either 2-D5 :5 A .C3; or 2,D5. #f cash flow in year , A 2,13! can sell the in$estment for either 21-3 :5 A .53; or 2113. +he initial in$estment for the firm is 2533!333 after tax. +he firm uses a cost of capital of 13 percent. a. Construct a decision tree with the expected 456 of each alternati$e.
Answer7 ,ash /lows an probabilities are shown below7 Ci$e 1 Ci$e 2 Ci$e 3 >PV Prob

3.D3
&-%& ;<<<<<<<<<< 3!& <4%-*% &-21

Chapter 5: Risk Analysis in Capital Budgeting

;<<<<<<<<<< 12& <<<E &-3& F A<<<<<<<<<< 2!& <122-&* &-&* F

&-!& F F F F F <<E F F F F F &-!&

OBBBBBBBB 133 BBBP

F &-%& F &-4& ;<<<<<<<<<< 12! <23%-%% &-12 A<<<<<<<<<< *! <<<E &-4& A<<<<<<<<<< )! <2)4-23 &-&+ &-+& &-!& ;<<<<<<<<<< 4)! 24!-3& &-2& ;<<<<<<<<< 2!& <<<E &-2& F A<<<<<<<<<< 2)! *!-&4 &-&! F F &-!& F &-!& ;<<<<<<<<<< 14& <3*-44 &-12! A<<<<<<<<< 21& <<<E &-!& A<<<<<<<<<< 11& <%1-*+ &-12!

QBBBBBBBB ,33 BBBBP

'. .hat is the expected 456 of the 'est possi'le outcome? .hat is its pro'a'ility? Answer: +he 'est possi'le outcome has 456:333%s; A 2,-5.=3. #ts associated pro'a'ility is 3.,3. c. .hat is the expected 456 of the worst possi'le outcome? .hat is its pro'a'ility? Answer: +he worst possi'le outcome has 456:333%s; A B2,D-.,=. +he pro'a'ility of attaining this outcome is 3.3C. d. 9hould +eletech make the in$estment? .hy or why not? Answer: +eletech should likely not make the in$estment since the expected net present $alue is negati$e. E. Refer to the 9tarship pro ect in 9ection ,. a. .hat would the 'reak1e$en 0uantity 'e initially if the cost of capital for the pro ect were estimated at 1- percent rather than 13 percent? Answer: #3 B H (

# = +
PV"FDr(n (P<V)(1<t) P<V

2!& < 12&

1!

L A BBBBBBBBBBBBBBBBBBBBB I BBBBBBB A 5-.3= units.

Chapter 5: Risk Analysis in Capital Budgeting

!-21%1 (2-)<1-!)(&-!) 2-)<1-!

bGhat woul the brea34e#en 1uantit0 be i/ the Starship coul be sol /or onl0 '2(&&&(&&& each (assu$e a cost o/ capital o/ 1& percent)H

Answer: ,53 B 1,3 15 L A BBBBBBBBBBBBBBBBBBBBB I BBBBBBB A 11-.G= units. G.1--G :,.3B1.5;:3.5; ,.3B1.5 c. .hat would the 'reak1e$en 0uantity 'e if cost o$erruns increased the initial in$estment from 21=3!333!333 to 2,=3!333!333? Answer: =53 B 1,3 15 L A BBBBBBBBBBBBBBBBBBBBB I BBBBBBB A D-.CE units. G.1--G :,.DB1.5;:3.5; ,.DB1.5 13. +he following exhi'it contains Beech%s estimates of demand! price! and fixed and $aria'le costs for the 9tarship under three alternati$e economic forecasts.
Variable (per 0ear) Je$an PriceK Fixe costK Variable costK Pessi$istic !& 2 22 1-)! >or$al )! 2-) 1! 1-!& Ipti$istic 12! 3-2 ) 1-&

a. #f all other $aria'les are assumed to 'e at their expected $alue :normal forecast;! how sensiti$e is the pro ect%s 456 to changes in fixed cost? Rse a cost of capital of 13 percent! tax rate of =5 percent! and pro ect life of ten years. Answer: 456 A B#n$ I H I :Hemand:5riceB6ar;B(ixed;:1Btax;:56#(A; 4ormal Case: 456 A B,53 I 1,3 I :D5:,.DB1.5;B15;:3.G5;:G.1--G; A 21GE.55*
Variable Pess >or$ Ipt >PV(Pess) >PV(Ipt) Je$an !& )! 12! 4*-)3 4&*-1* Fixe ,ost 22 1! ) <4&-14 31*-32

'. &ow sensiti$e is the pro ect%s 456 to changes in price?

Answer7 Price Answer7 Var- cost Variable Pess >or$ Ipt >PV(Pess) >PV(Ipt) 2 2-) 3-2 141-!* 2&1-!& Variable 1-)! 1-! Pess >or$ 1-& *4-%% Ipt >PV(Pess) >PV(Ipt) 31*-32

c. &ow sensiti$e is the pro ect%s 456 to changes in $aria'le cost? d. .hich factor seems most important to the success of the plane? Answer: (ixed costs can make the pro ect unprofita'le. +he same greatest dollar $ariation in 456! howe$er! can 'e achie$ed 'y changing either demand or fixed costs. e. #s the 9tarship a risky pro ect? 7xplain. Answer: #n the sense of total $olatility! the pro ect is risky. &owe$er! in$estors may 'e a'le to di$ersify this risk. #n the sense of guaranteeing a positi$e 456! the pro ect is not $ery risky< only

Chapter 5: Risk Analysis in Capital Budgeting in one scenario will 456 'ecome negati$e.