Advanced Corporate Finance Leonidas Rompolis
EXERCISES -4 (SOLUTIONS)
Chapter 10, Practice Questions
2. The spreadsheets show the following results:
NPV (billions of yen)
Pessimistic Expected Optimistic
-1.2 3.4 8.0
-10.4 3.4 17.3
-19.6 3.4 11.1
-11.9 3.4 11.1
-2.7 3.4 9.6
The principal uncertainties are market share, unit price, and unit variable cost.
9. The expected cash flow is: 45 × 0.25 + 35 × 0.5 + 25 × 0.25 − 25 = 10
10
a. NPV = −90 + = −6.66 and the factory should not be built.
0.12
b. At the beginning of year 2 we have the option to continue production or to sell the
10
factory. In the first case the value of the project is = 83.33 . In the second case
0.12
the value is just the market price, i.e. 50. We observe that is more valuable to
continue the project, therefore we do not exercise the option to abandon. However, as
answer (a) implies neither this possibility should be accepted since the NPV is
negative.
1. If Rustic replaces now rather than in one year, several things happen:
i. It incurs the equivalent annual cost of the $9 million capital investment.
ii. It reduces manufacturing costs.
For example, for the “Expected” case, analyzing “Sales” we have (all dollar figures in
millions):
The economic life of the new machine is expected to be 10 years, so the equivalent
annual cost of the new machine is: $9/5.6502 = $1.59
The reduction in manufacturing costs is: 0.5 × $4 = $2.00
Thus, the equivalent annual cost savings is: –$1.59 + $2.00 = $0.41
Continuing the analysis for the other cases, we find:
Equivalent Annual Cost Savings (Millions)
Pessimistic Expected Optimistic
Sales 0.01 0.41 1.21
Manufacturing Cost -0.59 0.41 0.91
Economic Life 0.03 0.41 0.60
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Advanced Corporate Finance Leonidas Rompolis
2. a.
Year 0 Years 1-10
Investment 30 B
1. Revenue 37.500 B
2. Variable Cost 26.000
3. Fixed Cost 3.000
4. Depreciation 3.000
5. Pre-tax Profit (1-2-3-4) 5.500
6. Tax 1.925
7. Net Operating Profit (5-6) 3.575
8. Operating Cash Flow (4+7) 6.575
NPV = 10.40 B
b. The following table displays the data of the break-even chart.
Inflows Outflows
Unit Sales Revenues Investment V. Costs F. Cost Taxes PV PV NPV
(000’s) Yrs 1-10 Yr 0 Yr 1-10 Yr 1-10 Yr 1-10 Inflows Outflows
0 0.00 30.00 0.00 3.00 -2.10 0.0 -35.5 -35.5
100 37.50 30.00 26.00 3.00 1.93 230.4 -220.0 10.4
200 75.00 30.00 52.00 3.00 5.95 460.8 -404.5 56.3
Break-even chart
80
60
40
20
NPV
0
-20 0 50 100 150 200 250
-40
-60
unit sales
Note that the break-even point can be found algebraically as follows:
NPV = -Investment + [(PVA10/10%) × (τc × Depreciation)] +
[Quantity × (Price – V.Cost) – F.Cost]×(1 – τc)×(PVA10/10%)
Set NPV equal to zero and solve for Q:
I - (PVA10/10% ×D×τc ) FC
Q= +
(PVA10/10% )×(P - VC)×(1 - τc ) P - VC
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Advanced Corporate Finance Leonidas Rompolis
30,000,000,000 - 6,451,795,461 3,000,000,000
= +
(6.144567)×(375,000 - 260,000)×(0.65) 375,000 - 260,000
23,548,204,539 3,000,000,000
= + =51,269+26,087=77,356
459,306 115,000
c. The break-even point is the point where the present value of the cash flows,
including the opportunity cost of capital, yields a zero NPV.
d. To find the level of costs at which the project would earn zero profit, write the
equation for net profit, set net profit equal to zero, and solve for variable costs:
Net Profit = (R – VC – FC - D) × (1 – τc)
0 = (37.5 – VC – 3.0 – 1.5) × (0.65)
VC = 33.0
This will yield zero profit.
Next, find the level of costs at which the project would have zero NPV. Using the
data in Table 10.1, the equivalent annual cash flow yielding a zero NPV would be:
15 B/PVA10/10% = 2.4412 B
If we rewrite the cash flow equation and solve for the variable cost:
NCF = [(R – VC – FC – D) × (1 – τc)] + D
2.4412 = [(37.5 – VC – 3.0 – 1.5) × (0.65)] + 1.5
VC = 31.55
This will yield NPV = 0, assuming the tax credits can be used elsewhere in the
company.
3.
Year 5: 10000 trials
180
160
140
120
frequencies
100
80
60
40
20
0
cash flows (yen billion)
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Advanced Corporate Finance Leonidas Rompolis
Year 10: 10000 trials
140
120
100
frequencies
80
60
40
20
0
cash flows (yen billion)
4. Expand
High
Quit
demand
(60%)
Pilot Observe
production demand
and market
tests Expand
Low
demand
(40%)
Quit
7.5
If the demand is high the NPV is: NPV = −50 + = 12.5 , therefore it will be better
0.12
to expand.
3
If the demand is low the NPV is: NPV = −50 + = −25 , and it will be better to
0.12
quit.
Therefore, the total NPV of the project is:
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Advanced Corporate Finance Leonidas Rompolis
0.6 × 12.5
NPV = −5 + = −1.17
1.42
and the project should not be accepted.
5. We analyze the decision tree by working backwards. So, for example, if we purchase
the piston plane and demand is high:
The NPV at t = 1 of the ‘Expanded’ branch is:
(0.8×800) + (0.2×100)
-150 + = $461
1.08
The NPV at t = 1 of the ‘Continue’ branch is:
(0.8×410) + (0.2×180)
= $337
1.08
Thus, if we purchase the piston plane and demand is high, we should expand further
at t = 1. This branch has the highest NPV.
Similarly, if we purchase the piston plane and demand is low:
The NPV of the ‘Continue’ branch is:
(0.4×220) + (0.6×100)
= $137
1.08
We can now use these results to calculate the NPV of the ‘Piston’ branch at t = 0:
(0.6)×(100 + 461) + (0.4)×(50 + 137)
-180 + = $201
1.08
Similarly for the ‘Turbo’ branch, if demand is high, the expected cash flow at t = 1 is:
(0.8 × 960) + (0.2 × 220) = $812
If demand is low, the expected cash flow is:
(0.4 × 930) + (0.6 × 140) = $456
So, for the ‘Turbo’ branch, the combined NPV is:
(0.6×150) + (0.4×30) (0.6×812) + (0.4×456)
NPV=-350+ + = $319
(1.08) (1.08) 2
Therefore, the company should buy the turbo plane.
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Advanced Corporate Finance Leonidas Rompolis
In order to determine the value of the option to expand, we first compute the NPV
without the option to expand:
(0.6×100) + (0.4×50)
NPV=-250+ +
(1.08)
(0.6)[(0.8×410) + (0.2×180)]+(0.4)[(0.4×220)+(0.6×100)]
= $62.07
(1.08) 2
Therefore, the value of the option to expand is: $201 – $62 = $139
Hi demand (.8)
Continue $960
Hi demand (.6) Lo demand (.2)
$150 $220
Hi demand (.4)
Continue $930
Lo demand (.4) Lo demand (.6)
Turbo $30 $140
-$350
Hi demand (.8)
Expand $800
-$150 Lo demand (.2)
Piston $100
-$180 Hi demand (.8)
Hi demand (.6) Continue $410
$100 Lo demand (.2)
$180
Hi demand (.4)
Continue $220
Lo demand (.4) Lo demand (.6)
$50 $100
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Advanced Corporate Finance Leonidas Rompolis
6. First, consider the sequence of events:
At t = 0, the investment of $25,000,000 is made.
At t = 1, production begins, so the first year of revenue and expenses is
recorded at t = 2.
At t = 6, the patent expires and competition may enter. Since it takes one year
to achieve full production, competition is not a factor until t = 7. (This
assumes the competition does not begin construction until the patent expires.)
After t = 7, full competition will exist and thus any new entrant into the
market will earn the 9% cost of capital.
Next, calculate the cash flows:
At t = 0: –$25,000,000
At t = 1: $0
At t = 2, 3, 4, 5, 6: Sale of 200,000 units at $100 each, with costs of $65 each,
yearly cash flow = $7,000,000.
After t = 6, the NPV of new investment must be zero. Hence, to find the
selling price per unit (P) solve the following for P:
200,000×(P - 65) 200,000×(P-65)
0 = -25,000,000 + 2
+ ...+
1.09 1.0912
Solving, we find P = $85.02 so that, for years t = 7 through t = 12, the yearly cash
flow will be: [200,000 × ($85.02 - $65)] = $4,004,000.
Finally, the net present value (in millions):
7 7 7 4.004 4.004
NPV = -25 + 2
+ 3
+ ... + 6
+ 7
+ ... +
1.09 1.09 1.09 1.09 1.0912
NPV = $10.69 or $10,690,000
7. The selling price after t = 6 now changes because the required investment is:
[$25,000,000×(1 - 0.03)5] = $21,468,351
After t = 5, the NPV of new investment must be zero, and hence the selling price per
unit (P) is found by solving the following equation for P:
(200,000)×(P - 65) (200,000)×(P-65)
0 = -21,468,351 + 2
+ ... +
1.09 1.0912
P = $82.19
Thus, for years t = 7 through t = 12, the yearly cash flow will be:
[200,000 × ($82.19 - $65)] = $3,438,000
Finally, the net present value (in millions) is:
7 7 7 3.438 3.438
NPV = -25 + 2
+ 3
+ ... + 6
+ 7
+ ... +
1.09 1.09 1.09 1.09 1.0912
NPV = $9.18 or $9,180,000
