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Chapter 8: Strategy and Analysis in Using Net Present Value
8.1 ∙ What are the ways a firm can create positive NPV.
1. Be first to introduce a new product.
2. Further develop a core competency to product goods or services at lower costs than competitors.
3. Create a barrier that makes it difficult for the other firms to compete effectively.
4. Introduce variation on existing products to take advantage of unsatisfied demand
5. Create product differentiation by aggressive advertising and marketing networks.
6. Use innovation in organizational processes to do all of the above.
∙ How can managers use the market to help them screen out negative NPV projects?
8.2 ∙ What is a decision tree?
It is a method to help capital budgeting decision-makers evaluating projects involving sequential decisions. At every point in the tree, there are different alternatives that should be analyzed.
∙ What are potential problems in using a decision tree?
Potential problems 1) that a different discount rate should be used for different branches in the tree and 2) it is difficult for decision trees to capture managerial options.
8.3 ∙ What is a sensitivity analysis?
It is a technique used to determine how the result of a decision changes when some of the parameters or assumptions change.
∙ Why is it important to perform a sensitivity analysis?
Because it provides an analysis of the consequences of possible prediction or assumption errors.
∙ What is a break-even analysis?
It is a technique used to determine the volume of production necessary to break even, that is, to cover not only variable costs but fixed costs as well.
∙ Describe how sensitivity analysis interacts with break-even analysis.
Sensitivity analysis can determine how the financial break-even point changes when some factors (such as fixed costs, variable costs, or revenue) change.
Answers to End-of-Chapter Problems
Decision Trees
8.1 Sony Electronics, Inc., has developed a new type of VCR. If the firm directly goes to the market with the product, there is only a 50 percent chance of success. On the other hand, if the firm conducts test marketing of the VCR, it will take a year and will cost $2 million.
Through the test marketing, however, the firm is able to improve the product and increase the probability of success to 75 percent. If the new product proves successful, the present value (at the time when the firm starts selling it) of the payoff is $20 million, while if it turns out to be a failure, the present value of the payoff is $5 million. Should the firm conduct test marketing or go directly to the market? The appropriate discount rate is 15 percent.
8.1 Go directly:
NPV = 0.5 ⨯ $20 million + 0.5 ⨯ $5 million
= $12.5 million
Test marketing:
NPV = -$2 million + (0.75 ⨯ $20 million + 0.25 ⨯ $5 million) / 1.15
= $12.13 million
Go directly to the market.
8.2 The marketing manager for a growing consumer products firm is considering launching a new product. To determine consumers’ interest in such a product, the manager can conduct a focus group that will cost $120,000 and has a 70 percent chance of correctly predicting the success of the product, or hire a consulting firm that will research the market at a cost of $400,000. The consulting firm boasts a correct assessment record of 90 percent. Of course going directly to the market with no prior testing will be the correct move 50 percent of the time. If the firm launches the product, and it is a success, the payoff will be $1.2 million.
Which action will result in the highest expected payoff for the firm?
8.2 Focus group: -$120,000 + 0.70 ⨯ $1,200,000 = $720,000
Consulting firm: -$400,000 + 0.90 ⨯ $1,200,000 = $680,000
Direct marketing: 0.50 ⨯ $1,200,000 = $600,000
The manager should conduct a focus group.
8.3 Tandem Bicycles is noticing a decline in sales due to the increase of lower-priced import products from the Far East. The CFO is considering a number of strategies to maintain its market share. The options she sees are the following:
• Price the products more aggressively, resulting in a $1.3 million decline in cash flows.
The likelihood that Tandem will lose no cash flows to the imports is 55 percent; there is a
45 percent probability that they will lose only $550,000 in cash flows to the imports.
• Hire a lobbyist to convince the regulators that there should be important tariffs placed upon overseas manufacturers of bicycles. This will cost Tandem $800,000 and will have a 75 percent success rate, that is, no loss in cash flows to the importers. If the lobbyists do not succeed, Tandem Bicycles will lose $2 million in cash flows. As the assistant to the CFO, which strategy would you recommend to your boss?
Accounting Break-Even Analysis
8.3 Price more aggressively:
-$1,300,000 + (0.55 ⨯ 0) + 0.45 ⨯ (-$550,000)
= -$1,547,500
Hire lobbyist:
-$800,000 + (0.75 ⨯ 0) + 0.25 ⨯ (-$2,000,000)
= -$1,300,000
Tandem should hire the lobbyist.
8.4 Samuelson Inc. has invested in a facility to produce calculators. The price of the machine is $600,000 and its economic life is five years. The machine is fully depreciated by the straight-line method and will produce 20,000 units of calculators in the first year. The variable production cost per unit of the calculator is $15, while fixed costs are $900,000. The corporate tax rate for the company is 30 percent. What should the sales price per unit of the calculator be for the firm to have a zero profit?
8.4 Let sales price be x.
Depreciation = $600,000 / 5 = $120,000
BEP: ($900,000 + $120,000) / (x - $15) = 20,000
x = $66
8.5 What is the minimum number of units that a distributor of big-screen TVs must sell in a given period to break even?
Sales price _ $1,500
Variable costs _ $1,100
Fixed costs _ $120,000
Depreciation _ $20,000
Tax rate _ 35%
8.5 The accounting break-even
= (120,000 + 20,000) / (1,500 - 1,100)
= 350 units
8.6 You are considering investing in a fledgling company that cultivates abalone for sale to local restaurants. The proprietor says he’ll return all profits to you after covering operating costs and his salary. How many abalone must be harvested and sold in the first year of operations for you to get any payback? (Assume no depreciation.)
Price per adult abalone _ $2.00
Variable costs _ $0.72
Fixed costs _ $300,000
Salaries _ $40,000
Tax rate _ 35%
How much profit will be returned to you if he sells 300,000 abalone?
8.6 a. The accounting break-even
= 340,000 / (2.00 - 0.72)
= 265,625 abalones
b. [($2.00 ⨯ 300,000) - (340,000 + 0.72 ⨯ 300,000)] (0.65)
= $28,600
This is the after tax profit.
Present Value Break-Even Analysis
8.7 Using the information in the problem above, what is the present value break-even point if the discount rate is 15 percent, initial investment is $140,000, and the life of the project is seven years? Assume a straight-line depreciation method with a zero salvage value.
8.7 EAC = $140,000 / 12c352e79faefa7bc3034dd69a9bddd2.png
Depreciation = $140,000 / 7 = $20,000
BEP = {$33,650 + $340,000 ⨯ 0.65 - $20,000 ⨯ 0.35} / {($2 - $0.72) ⨯ 0.65}
= 297,656.25
≈ 297,657 units
8.8 Kids & Toys Inc. has purchased a $200,000 machine to produce toy cars. The machine will be fully depreciated by the straight-line method for its economic life of five years and will be worthless after its life. The firm expects that the sales price of the toy is $25 while its variable cost is $5. The firm should also pay $350,000 as fixed costs each year. The corporate tax rate for the company is 25 percent, and the appropriate discount rate is 12 percent. What is the present value break-even point?
8.8 Depreciation = $200,000 / 5 = $40,000
EAC = $200,000 / 10a9ca4ed2bced688c1ed5edfe5b9c5f.png
= $55,482
BEP = {$55,482 + $350,000 ⨯ 0.75 - $40,000 ⨯ 0.25} / {($25 - $5) ⨯ 0.75}
= 20,532.13
≈ 20533 units
8.9 The Cornchopper Company is considering the purchase of a new harvester. The company is currently involved in deliberations with the manufacturer and the parties have not come to settlement regarding the final purchase price. The management of Cornchopper has hired you to determine the break-even purchase price of the harvester.
This price is that which will make the NPV of the project zero. Base your analysis on the following facts:
• The new harvester is not expected to affect revenues, but operating expenses will be reduced by $10,000 per year for 10 years.
• The old harvester is now 5 years old, with 10 years of its scheduled life remaining. It was purchased for $45,000. It has been depreciated on a straight-line basis.
• The old harvester has a current market value of $20,000.
• The new harvester will be depreciated on a straight-line basis over its 10-year life.
• The corporate tax rate is 34 percent.
• The firm’s required rate of return is 15 percent.
• All cash flows occur at year-end. However, the initial investment, the proceeds from selling the old harvester, and any tax effects will occur immediately. Capital gains and losses are taxed at the corporate rate of 34 percent when they are realized.
• The expected market value of both harvesters at the end of their economic lives is zero.
8.9 Let I be the break-even purchase price.
Incremental C0
Sale of the old machine $20,000
Tax effect 3,400
Total $23,400
Depreciation per period
= $45,000 / 15
= $3,000
Book value of the machine
= $45,000 - 5 ⨯ $3,000
= $30,000
Loss on sale of machine
= $30,000 - $20,000
= $10,000
Tax credit due to loss
= $10,000 ⨯ 0.34
= $3,400
Incremental cost savings:
$10,000 (1 - 0.34) = $6,600
Incremental depreciation tax shield:
[I / 10 - $3,000] (0.34)
The break-even purchase price is the Investment (I), which makes the NPV be zero.
NPV = 0
= -I + $23,400 + $6,600 a26587514c67baa4cfcb4c07a6eceffe.png
+ [I / 10 - $3,000] (0.34) a26587514c67baa4cfcb4c07a6eceffe.png
= -I + $23,400 + $6,600 (5.0188)
+ I (0.034) (5.0188) - $3,000 (0.34) (5.0188)
I = $61,981
Scenario Analysis
8.10 Ms. Thompson, as the CFO of a clock maker, is considering an investment of a $420,000 machine that has a seven-year life and no salvage value. The machine is depreciated by a straight-line method with a zero salvage over the seven years. The appropriate discount rate for cash flows of the project is 13 percent, and the corporate tax rate of the company is 35 percent. Calculate the NPV of the project in the following scenario. What is your conclusion about the project?
Pessimistic Expected Optimistic
Unit sales 23,000 25,000 27,000
Price $ 38 $ 40 $ 42
Variable costs $ 21 $ 20 $ 19
Fixed costs $320,000 $300,000 $280,000
8.10 Pessimistic:
NPV = -$420,000 + word/media/image6_1.png
= -$123,021.71
Expected:
NPV = -$420,000 + word/media/image7_1.png
= $247,814.17
Optimistic:
NPV = -$420,000 + word/media/image8_1.png
= $653,146.42
Even though the NPV of pessimistic case is negative, if we change one input while all others are assumed to meet their expectation, we have all positive NPVs like the one before. Thus, this project is quite profitable.
8.11 You are the financial analyst for a manufacturer of tennis rackets that has identified a graphite-like material that it is considering using in its rackets. Given the following information about the results of launching a new racket, will you undertake the project?
(Assumptions: Tax rate _ 40%, Effective discount rate _ 13%, Depreciation _ $300,000
per year, and production will occur over the next five years only.)
Pessimistic Expected Optimistic
Market size 110,000 120,000 130,000
Market share 22% 25% 27%
Price $ 115 $ 120 $ 125
Variable costs $ 72 $ 70 $ 68
Fixed costs $ 850,000 $ 800,000 $ 750,000
Investment $1,500,000 $1,500,000 $1,500,000
8.11 Pessimistic:
NPV = -$1,500,000
+word/media/image9_1.png
= -$675,701.68
Expected:
NPV = -$1,500,000
+word/media/image10_1.png
= $399,304.88
Optimistic:
NPV = -$1,500,000
+word/media/image11_1.png
= $1,561,468.43
The expected present value of the new tennis racket is $428,357.21. (Assuming there are equal chances of the 3 scenarios occurring.)
8.12 What would happen to the analysis done above if your competitor introduces a graphite composite that is even lighter than your product? What factors would this likely affect? Do an NPV analysis assuming market size increases (due to more awareness of graphite-based rackets) to the level predicted by the optimistic scenario but your market share decreases to the pessimistic level (due to competitive forces). What does this tell you about the relative importance of market size versus market share?
8.12 NPV = word/media/image12_1.png
= $251,581.17
The 3% drop in market share hurt significantly more than the 10,000 increase in market size helped. However, if the drop were only 2%, the effects would be about even. Market size is going up by over 8%, thus it seems market share is more important than market size.
The Option to Abandon
8.13 You have been hired as a financial analyst to do a feasibility study of a new video game for Passivision. Marketing research suggests Passivision can sell 12,000 units per year at $62.50 net cash flow per unit for the next 10 years. Total annual operating cash flow is forecasted to be $62.50 _ 12,000 _ $750,000. The relevant discount rate is 10 percent.
The required initial investment is $10 million.
a. What is the base case NPV?
b. After one year, the video game project can be abandoned for $200,000. After one year,
word/media/image13.gifexpected cash flows will be revised upward to $1.5 million or to $0 with equal
probability. What is the option value of abandonment? What is the revised NPV?
8.13 a. NPV = -$10,000,000 + ( $750, 000 ⨯ 85529fbcf5c38d790f07adad2f81fb2f.png
b. Revised NPV = -$10,000,000 + $750,000 / 1.10 + [(.5 ⨯ $1,500,000 ⨯ a201105a4fd9f9b7aeea8f85273582ed.png
+ (.5 ⨯ $200,000 )] / 1.10
= -$5,300,665.58
Option value of abandonment = -$5,300,665.58 – ( -$5,391,574.67 )
= $90,909.09
8.14 Allied Products is thinking about a new product launch. The vice president of marketing suggests that Allied Products can sell 2 million units per year at $100 net cash flow per unit for the next 10 years. Allied Products uses a 20-percent discount rate for new product launches and the required initial investment is $100 million.
a. What is the base case NPV?
b. After the first year, the project can be dismantled and sold for scrap for $50 million. If expected cash flows can be revised based on the first year’s experience, when would it make sense to abandon the project? (Hint: At what level of expected cash flows does it make sense to abandon the project?)
8.14 a. NPV = -$100M + ( $100 ⨯ 2M ⨯ 13af14c823e126d1011f226df9a04ab9.png
b. $50M = Ce2527b58702a6c943738abf30efb717c.png
C = $12.40 Million (or 1.24 Million units )
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