QUESTION 1

The Rustic Welt Company is proposing to replace its old welt-making machinery with more modern
equipment. The new equipment costs $9 million (the existing equipment has zero salvage value). The
attraction of the new machinery is that it is expected to cut manufacturing costs from their current level of
$8 a welt to $4. However, as the following table shows, there is some uncertainty about both the future
sales and the performance of the new machinery:

Pessimistic Expected Optimistic

Sales, in million welts .4 .5 .7
Manufacting cost per welt 6 4 3
Life of new machinery in years 7 10 13

Conduct a sensitivity analysis of the replacement decision assuming a discount rate of 12%. Rustic does not
pay taxes. Calculate the NPV.

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Answers are displayed in red.
Assumptions and other problem notes are displayed at the very bottom.

Input variables:
Equipment cost $9,000,000
Current variable cost per welt $8.00

Pessimistic Expected Optimistic

Sales units 400,000 500,000 700,000
New variable cost per unit $6.00 $4.00 $3.00
Machine life in years 7 10 13
Discount rate 12%

Solution and Explanation:

Sensitivity to sales:
Pessimistic Expected Optimistic
Sales units 400,000 500,000 700,000
Cost per welt $4.00 $4.00 $4.00
Cost savings per welt $4 $4 $4
Total annual savings $1,600,000 $2,000,000 $2,800,000
Machine life in years 10 10 10

NPV
PV of savings $9,040,357 $11,300,446 $15,820,624
Less: Investment 9,000,000 9,000,000 9,000,000
NPV $40,357 $2,300,446 $6,820,624

Senstivity to manufacturing cost:

Pessismistic Expected Optimistic
Sales units 500,000 500,000 500,000
Cost per welt $6.00 $4.00 $3.00
Cost savings per welt $2.00 $4.00 $5.00
Total annual savings $1,000,000 $2,000,000 $2,500,000
Machine life in years 10 10 10

NPV
PV of savings $5,650,223 $11,300,446 $14,125,558
Less: Investment 9,000,000 9,000,000 9,000,000
NPV -$3,349,777 $2,300,446 $5,125,558

Sensitivity to machine life:

Pessismistic Expected Optimistic
Sales units 500,000 500,000 500,000
Cost per welt $4.00 $4.00 $4.00
Cost savings per welt $4.00 $4.00 $4.00
Total annual savings $2,000,000 $2,000,000 $2,000,000
Machine life in years 7 10 13

NPV
PV of savings $9,127,513 $11,300,446 $12,847,097
Less: Investment 9,000,000 9,000,000 9,000,000
NPV $127,513 $2,300,446 $3,847,097
QUESTION 2

Emperor’s Clothes Fashions can invest $5 million in a new plant for producing invisible makeup. The plant
has an expected life of 5 years, and expected sales are 6 million jars of makeup a year. Fixed costs are $2
million a year, and variable costs are $1 per jar. The product will be priced at $2 per jar. The plant will be
depreciated straight-line over 5 years to a salvage value of zero. The opportunity cost of capital is 10%,
and the tax rate is 40%

a. What is project NPV under these base-case assumptions?

b. What is NPV if variable costs turn out to be $1.20 per jar?
c. What is NPV if fixed costs turn out to be $1.5 million per year?

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Answers are displayed in red.
Assumptions and other problem notes are displayed at the very bottom.

Input variables:
Investment $5,000,000
Plant life in years 5
Annual sales units 6,000,000
Annual fixed costs $2,000,000
Variable cost per unit $1.00
Sales price per unit $2.00
Cost of capital 10.00%
Tax rate 40%
b. Revised variable cost per unit $1.20
c. Revised annual fixed costs $1,500,000

Solution and Explanation:

a:
Revenue $12,000,000 cf ncs cffa
Variable costs 6,000,000 0 -5000000
Fixed costs 2,000,000 1 $2,800,000 $2,800,000
Depreciation 1,000,000 2 $2,800,000 $2,800,000
EBT $3,000,000 3 $2,800,000 $2,800,000
Taxes 1,200,000 4 $2,800,000 $2,800,000
Net income $1,800,000 5 $2,800,000 $2,800,000

Operating cash flow $2,800,000

$5,614,202.95
PV of cash flows $10,614,203
Less: Investment 5,000,000
NPV $5,614,203 $5.61 million

b.
Revenue $12,000,000
Variable costs 7,200,000
Fixed costs 2,000,000
Depreciation 1,000,000
EBT $1,800,000
Taxes 720,000
Net income $1,080,000

Operating cash flow $2,080,000

PV of cash flows $7,884,836

Less: Investment 5,000,000
NPV $2,884,836 $2.88 million

c.
Revenue $12,000,000
Variable costs 6,000,000
Fixed costs 1,500,000
Depreciation 1,000,000
EBT $3,500,000
Taxes 1,400,000
Net income $2,100,000

Operating cash flow $3,100,000

PV of cash flows $11,751,439

Less: Investment 5,000,000
NPV $6,751,439 $6.75 million
QUESTION 3

The most likely outcomes for a particular project are estimated as follows:

Unit price $50

Variable cost $30
Fixed costs $300,000
Expected sales - units per year 30,000

However, you recognize that some of these estimates are subject to error. Suppose that each variable may
turn out to be either 10% higher or 10% lower than the initial estimate. The project will last for 10 years and
requires an initial investment of $1 million, which will be depreciated straight-line over the project life to a
final value of zero. The firm's tax rate is 35% and the required rate of return is 12%.

a. What is project NPV in the best-case scenario, that is, assuming all variables take on the best possible
value?
b. What is project NPV in the worst-case scenario?

All input values are shown in yellow. Only these values need changed to review algo versions.
Answers are displayed in red.
Assumptions and other problem notes are displayed at the very bottom.

Input variables:
Unit price $50
Variable cost $30
Fixed costs $300,000
Expected sales units per year 30,000
Plus/minus range 10%
Project life in years 10
Initial investment $1,000,000
Salvage value $0
Tax rate 35%
Required return 12%

Solution and Explanation:

a.
Sales price per unit $55
Variable cost per unit $27
Fixed costs $270,000
Sales units 33,000

Revenue $1,815,000
Variable costs 891,000
Fixed costs 270,000
Depreciation 100,000
EBT $554,000
Taxes 193,900
Net income $360,100

Operating cash flow $460,100

PV of cash flows $2,599,668

Less: Investment 1,000,000
NPV $1,599,668

b.
Sales price per unit $45
Variable cost per unit $33
Fixed costs $330,000
Sales units 27,000

Revenue $1,215,000
Variable costs 891,000
Fixed costs 330,000
Depreciation 100,000
EBT -$106,000
Taxes -37,100
Net income -$68,900
Operating cash flow $31,100

PV of cash flows $175,722

Less: Investment 1,000,000
NPV -$824,278
QUESTION 4

You estimate that your cattle farm will generate $1 million of profits on sales of $4 million under normal
economic conditions and that the degree of operating leverage is 8.

a. What will profits be if sales turn out to be $3.5 million?

b. What if they are $4.5 million?

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Answers are displayed in red.
Assumptions and other problem notes are displayed at the very bottom.

Input variables:
Profit $1.00 million
Sales $4 million
DOL 8
a. Sales $3.50 million
b. Sales $4.50 million

Solution and Explanation:

a.
% change in sales -12.50%
DOL 8
% change in profit -100%
New profit $0
Profit will decrease to $0 million.

b.
% change in sales 12.50%
DOL 8
% change in profit 100%
New profit $2.0 million
Profit will increase to $2.0 million.
QUESTION 5

A project has fixed costs of $1,000 per year, depreciation charges of $500 a year, annual revenue of
$6,000, and variable costs equal to two-thirds of revenues

a. If sales increase by 10%, what will be the increase in pretax profits?

b. What is the degree of operating leverage of this project?

All input values are shown in yellow. Only these values need changed to review algo versions.
Answers are displayed in red.
Assumptions and other problem notes are displayed at the very bottom.

Input variables:
Fixed costs $1,000
Depreciation $500
Revenue $6,000
Variable cost as % of sales .67 (input in this format: "= 2/3")
a. Sales increase percent 10%

Solution and Explanation:

Revenues $6,000
Variable costs 4,000
Fixed costs 1,000
Depreciation 500
Pretax profit $500

a.
Revenues $6,600
Variable costs 4,400
Fixed costs 1,000
Depreciation 500
Pretax profit $700

% change in profit 40.00%

b.
DOL 4.00