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Ross7e ch08
- 1. CHAPTER 8 Strategy and Analysis in Using Net Present Value
- 4. Example of Decision Tree Do not study Study finance Squares represent decisions to be made. Circles represent receipt of information e.g . a test score. The lines leading away from the squares represent the alternatives. “ C” “ A” “ B” “ F” “ D”
- 8. Decision Tree for Stewart Pharmaceutical Do not test Test Failure Success Do not invest Invest The firm has two decisions to make: To test or not to test. To invest or not to invest. NPV = $3.4 b NPV = $0 NPV = – $91.46 m Invest 0 $ NPV
- 15. Break-Even Revenue Stewart Pharmaceuticals Work backwards from OCF BE to Break-Even Revenue Revenue $5,358.72 Variable cost $3,000 Fixed cost $1,800 Depreciation $400 EBIT $158.72 Tax (34%) $53.97 Net Income $104.75 OCF = $104.75 + $400 $504.75 $104.75 0.66 + D + FC + VC
- 22. Dorm Beds OCF 3 We get our $10,000 NWC back and sell the equipment. The after-tax salvage value is $6,600 = $10,000 × (1 – .34) Thus, OCF 3 = $720,833.33 + $10,000 + $6,600 = $737,433.33 Revenue 10,000 × $200 = $2,000,000 Variable cost 10,000 × $90 = $900,000 Fixed cost $25,000 Depreciation 100,000 ÷ 3 = $33,333 EBIT $1,041,666.67 Tax (34%) $354,166.67 Net Income $687,500 OCF = $687,500 + $33,333 $720,833.33
- 27. Break-Even Revenue Work backwards from OCF BE to Break-Even Revenue Revenue 10,000 × $ P BE = $988,035.04 Variable cost 10,000 × $90 = $900,000 Fixed cost $25,000 Depreciation 100,000 ÷ 3 = $33,333 EBIT $29,701.71 Tax (34%) $10,098.58 Net Income $19,603.13 OCF = $19,603.13 + $33,333 $52,936.46 $19,603.13 0.66
- 30. Don’t Forget that Variable Cost Varies Revenue Q BE × $200 = $88,035.04 + Q BE × $110 Variable cost Q BE × $90 = $? Fixed cost $25,000 Depreciation 100,000 ÷ 3 = $33,333 EBIT $29,701.71 Tax (34%) $10,098.58 Net Income $19,603.13 OCF = $19,603.13 + $33,333 $52,936.46 $19,603.13 0.66
- 34. Present Value of Depreciation Tax Shield The PV of the depreciation tax shields on April 15, 2003 is $54,415.54. PMT I/Y FV PV N 13,600 7.92 0 – 54,415.54 5 PV
- 35. Present Value of Depreciation Tax Shield The PV of the depreciation tax shields on January 1 2003 is $53,176.99 53,176.99 PMT I/Y FV PV N 7.92 0 – 54,415.54 3.5 PV
- 38. Present Value of Tax Liability The PV of the tax liability is 16.32 times one month’s gross revenue on 15 April 2003. PMT I/Y FV PV N 7.92 – 12×0.34 × PBE 5 PV 16.32 × PBE
- 39. Present Value of Tax Liability The PV of the tax liability on January 1 2003 is 15.95 times the value of one month’s gross income 15.95 × P BE PMT I/Y FV PV N 7.92 0 16.32 × PBE 3.5 PV
- 41. Present Value of Gross Revenue The PV of 60 months of gross revenue on January 1 2003 is 49.41 times one month’s gross revenue PMT I/Y FV PV N 7.92 – 1 × P BE 60 PV 49.41× P BE
- 50. Campusteria pro forma Income Statement We plan to sell 25 meal plans at $200 per month with a 12-month contract. Variable costs are projected to be $3,500 per month. Fixed costs (the lease payment) are projected to be $1,500 per month. We can depreciate our capitalized leaseholder improvements. – $4,950 Net Profit $2,550 Tax shield 34% ($7,500) Pretax profit ($18,000) Fixed Costs Years 1-4 Year 0 Investment $2,550 – $30,000 Cash Flow ($7,500) Depreciation ($42,000) Variable Costs $60,000 Revenues 84 . 916 , 21 $ ) 10 . 1 ( 550 , 2 $ 000 , 30 $ 4 1 t t NPV
- 54. The Option to Abandon: Example Traditional NPV analysis would indicate rejection of the project. NPV = = – $38.64 1.10 $287.50 – $300 + Expected Payoff = (0.50×$575) + (0.50×$0) = $287.50 = Expected Payoff Prob. Success × Successful Payoff + Prob. Failure × Failure Payoff
- 55. The Option to Abandon: Example The firm has two decisions to make: drill or not, abandon or stay. Traditional NPV analysis overlooks the option to abandon. Do not drill Drill 0 $ NPV 500 $ Failure Success: PV = $500 Sell the rig; salvage value = $250 Sit on rig; stare at empty hole: PV = $0.
- 56. The Option to Abandon: Example When we include the value of the option to abandon, the drilling project should proceed: NPV = = $75.00 1.10 $412.50 – $300 + Expected Payoff = (0.50×$575) + (0.50×$250) = $412.50 = Expected Payoff Prob. Success × Successful Payoff + Prob. Failure × Failure Payoff
Editor's Notes
- Well, maybe you could get a “C” without studying.
- If you don’t invest, the NPV = 0 even if you test first, because the cost of testing becomes a sunk cost. If you are so unwise as to invest in the face of a failed test, you incur lots of additional costs, but not much in the way of revenue, so you have a negative NPV as of date 1 of -$3,611. I didn’t think adding the calculations aided the pedagogy, so I left it off.
- Note the irony of scenario 1: our workers are too sick to make the medicine.
- To find 3.16987, use your financial calculator to find the PV of an annuity that pays $1 per period for 4 periods when the discount rate is 10%.
- To find 3.16987, use your financial calculator to find the PV of an annuity that pays $1 per period for 4 periods when the discount rate is 10%.
- Well, maybe you could get a “C” without studying.
- NPV 0 = NPV t / (1.10) t