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Exercise7 - Solutions

The document discusses a sensitivity analysis and scenario analysis for a project with projected sales, costs, and cash flows. It calculates the base NPV and how the NPV changes with a 1% increase in sales. It also considers best and worst case scenarios where projections vary by 10% and calculates the resulting NPV ranges. It then defines the trade-off theory of capital structure as weighing the tax advantages of debt against bankruptcy costs to determine an optimal leverage ratio.

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Marine Lal
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54 views2 pages

Exercise7 - Solutions

The document discusses a sensitivity analysis and scenario analysis for a project with projected sales, costs, and cash flows. It calculates the base NPV and how the NPV changes with a 1% increase in sales. It also considers best and worst case scenarios where projections vary by 10% and calculates the resulting NPV ranges. It then defines the trade-off theory of capital structure as weighing the tax advantages of debt against bankruptcy costs to determine an optimal leverage ratio.

Uploaded by

Marine Lal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Exercise 7 (Solutions)

1. Sensitivity Analysis. We are evaluating a project that costs $1.68 million, has a 6-year
life, and has no salvage value. Assume that depreciation is straight-line to zero over the
life of the project. Sales are projected at 90,000 units per year. Price per unit is $37.95,
variable cost per unit is $23.20, and fixed costs are $815,000 per year. The tax rate is 21
percent, and we require a return of 11 percent on this project.
a. Calculate the base-case operating cash flow and NPV.
b. Calculate NPV if the projected sale is 91,000 units per year instead of 90,000. Based
on the answers to the above questions, what is the sensitivity of NPV to the percentage
change in the sales figure?
Answer:
Depreciation/yr = $1,680,000/6 = $280,000

The OCF in the base-case is:

OCFbase = [($37.95 – 23.20)(90,000) – $815,000 – $280,000](1– .21) + $280,000


OCFbase = $463,675

Now we can calculate the NPV using our base-case projections. There is no salvage value or
NWC, so the NPV is:

NPVbase = –$1,680,000 + $463,675*({1 – [1/(1 + 0.11)]6}/0.11)


NPVbase = $281,594.64

To calculate the sensitivity of the NPV to the percentage change in the quantity sold, we will
calculate the NPV at a different quantity. We will use sales of 91,000 units. The NPV at this
sales level is:

OCFnew = [($37.95 – 23.20)(91,000) – $815,000– $280,000](1– .21) + $280,000


OCFnew = $475,327.50

And the NPV is:

NPVnew = –$1,680,000 + $475,327.50*({1 – [1/(1 + 0.11)]6 }/0.11)


NPVnew = $330,890.98

So, the sensitivity of NPV to the percentage change in sales is:

%NPV/%S = [($330,890.98 – 281,594.64)/ 281,594.64]/[(91,000 – 90,000)/ 90,000]


%NPV/%S = 15.76
2. Scenario Analysis. In the previous problem, suppose the projections given for price,
quantity, variable costs, and fixed costs are all accurate to within ±10 percent. Calculate
the best-case and worst-case NPV figures.
Answer:
For the best-case scenario, the price and quantity increase by 10 percent, so we will multiply the
base case numbers by 1.1, a 10 percent increase. The variable and fixed costs both decrease by 10
percent, so we will multiply the base case numbers by .9, a 10 percent decrease. Doing so, we
get:

OCFbest = {[$37.95(1.1) – $23.20(.9)](90,000)(1.1) – $815,000(.9) – $280,000}(.79) + $280,000


OCFbest = $1,111,186.65

The best-case NPV is:

NPVbest = –$1,680,000 + $1,111,186.65*({1 – [1/(1 + 0.11)]6 }/0.11)


NPVbest = $3,020,917.9

For the worst-case scenario, the price and quantity decrease by 10 percent, so we will multiply
the base case numbers by .9, a 10 percent decrease. The variable and fixed costs both increase by
10 percent, so we will multiply the base case numbers by 1.1, a 10 percent increase. Doing so, we
get:

OCFworst = {[$37.95(.9) – $23.20(1.1)](90,000)(.9) – $815,000(1.1) – $280,000}(.79) + $280,000


OCFworst = –$96,881.35

The worst-case NPV is:

NPVworst = –$1,680,000 – $96,881.35*({1 – [1/(1 + 0.11)]6 }/0.11)


NPVworst = –$2,089,860.22

3. What is the idea of the trade-off theory of capital structure?

Answer:
The trade-off theory of capital structure illustrates that corporate financial leverage is determined by
weighing the tax-saving advantages of debt against the prospective costs of bankruptcy. When
leverage is relatively low, the probability of bankruptcy is also minimal, causing the benefits of the
interest tax shield to surpass the anticipated bankruptcy costs. In this scenario, the firm might opt to
enhance its financial leverage to harness more of the tax shield's benefits. However, once the tax shield
benefits match the projected bankruptcy costs, the firm theoretically achieves its optimal leverage
ratio. Increasing leverage beyond this point will elevate the risk of bankruptcy and, in turn, the
associated expected costs.

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