Build a Model Solution 8/13/15Note: when creating student version, be sure to delete Scenario Summary worksheet. Also delete the Best and Worse case scenarios from the Scenario Manager. Also delete this message in the student version.Chapter:11Estimating Cash Flows and Analyzing RiskProblem:18Webmasters.com has developed a powerful new server that would be used for corporations’ Internet activities. It would cost $10 million at Year 0 to buy the equipment necessary to manufacture the server. The project would require net working capital at the beginning of each year in an amount equal to 10% of the year's projected sales; for example, NWC0 = 10%(Sales1). The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 3%. The company’s nonvariable costs would be $1 million at Year 1 and would increase with inflation. The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. Also, the project's returns are expected to be highly correlated with returns on the firm's other assets. The firm believes it could sell 1,000 units per year. The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of the equipment at the end of the project’s 4-year life is $500,000. Webmasters’ federal-plus-state tax rate is 40%. Its cost of capital is 10% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 and 1.2. Low-risk projects are evaluated with a WACC of 8%, and high-risk projects at 13%.a. Develop a spreadsheet model, and use it to find the project’s NPV, IRR, and payback. Input Data (in thousands of dollars)Equipment cost$10,000Key Results:Net operating working capital/Sales10% NPV =$3,463First year sales (in units)1,000 IRR =21.1%Sales price per unit$24.00 Payback =2.90Variable cost per unit (excl. depr.)$17.50Nonvariable costs (excl. depr.)$1,000Market value of equipment at Year 4$500Tax rate40%WACC10%Inflation in prices and costs3.0%Estimated salvage value at year 4$500Intermediate Calculations01234Units sold1,0001,0001,0001,000Sales price per unit (excl. depr.)$24.00$24.72$25.46$26.23Variable costs per unit (excl. depr.)$17.50$18.03$18.57$19.12Nonvariable costs (excl. depr.)1,0001,0301,0611,093Sales revenue$24,000$24,720$25,462$26,225Required level of net operating working capital$2,400$2,472$2,546$2,623$0Basis for depreciation$10,000Annual equipment depr. rate20.00%32.00%19.20%11.52%Annual depreciation expense$2,000$3,200$1,920$1,152Ending Bk Val: Cost – Accum Dep'rn$10,000$8,000$4,800$2,880$1,728Salvage value$500Profit (or loss) on salvage-$1,228Tax on profit (or loss)-$491Net cash flow due to salvage$991YearsCash Flow Forecast01234Sales revenue$24,000$24,720$25,462$26,225Variable costs17,50018,02518,56619,123Nonvariable opera ...

1. Build a Model
Solution
8/13/15Note: when creating student version, be sure to delete
Scenario Summary worksheet. Also delete the Best and Worse
case scenarios from the Scenario Manager. Also delete this
message in the student version.Chapter:11Estimating Cash
Flows and Analyzing RiskProblem:18Webmasters.com has
developed a powerful new server that would be used for
corporations’ Internet activities. It would cost $10 million at
Year 0 to buy the equipment necessary to manufacture the
server. The project would require net working capital at the
beginning of each year in an amount equal to 10% of the year's
projected sales; for example, NWC0 = 10%(Sales1). The
servers would sell for $24,000 per unit, and Webmasters
believes that variable costs would amount to $17,500 per unit.
After Year 1, the sales price and variable costs will increase at
the inflation rate of 3%. The company’s nonvariable costs
would be $1 million at Year 1 and would increase with
inflation. The server project would have a life of 4 years. If
the project is undertaken, it must be continued for the entire 4
years. Also, the project's returns are expected to be highly

2. correlated with returns on the firm's other assets. The firm
believes it could sell 1,000 units per year. The equipment
would be depreciated over a 5-year period, using MACRS rates.
The estimated market value of the equipment at the end of the
project’s 4-year life is $500,000. Webmasters’ federal-plus-
state tax rate is 40%. Its cost of capital is 10% for average-risk
projects, defined as projects with a coefficient of variation of
NPV between 0.8 and 1.2. Low-risk projects are evaluated with
a WACC of 8%, and high-risk projects at 13%.a. Develop a
spreadsheet model, and use it to find the project’s NPV, IRR,
and payback. Input Data (in thousands of dollars)Equipment
cost$10,000Key Results:Net operating working
capital/Sales10% NPV =$3,463First year sales (in units)1,000
IRR =21.1%Sales price per unit$24.00 Payback
=2.90Variable cost per unit (excl. depr.)$17.50Nonvariable
costs (excl. depr.)$1,000Market value of equipment at Year
4$500Tax rate40%WACC10%Inflation in prices and
costs3.0%Estimated salvage value at year 4$500Intermediate
Calculations01234Units sold1,0001,0001,0001,000Sales price
per unit (excl. depr.)$24.00$24.72$25.46$26.23Variable costs
per unit (excl. depr.)$17.50$18.03$18.57$19.12Nonvariable
costs (excl. depr.)1,0001,0301,0611,093Sales
revenue$24,000$24,720$25,462$26,225Required level of net
operating working capital$2,400$2,472$2,546$2,623$0Basis for
depreciation$10,000Annual equipment depr.

3. rate20.00%32.00%19.20%11.52%Annual depreciation
expense$2,000$3,200$1,920$1,152Ending Bk Val: Cost –
Accum Dep'rn$10,000$8,000$4,800$2,880$1,728Salvage
value$500Profit (or loss) on salvage-$1,228Tax on profit (or
loss)-$491Net cash flow due to salvage$991YearsCash Flow
Forecast01234Sales
revenue$24,000$24,720$25,462$26,225Variable
costs17,50018,02518,56619,123Nonvariable operating
costs1,0001,0301,0611,093Depreciation
(equipment)2,0003,2001,9201,152Oper. income before taxes
(EBIT)$3,500$2,465$3,915$4,858Taxes on operating income
(40%)1,4009861,5661,943Net operating profit after
taxes$2,100$1,479$2,349$2,915Add back
depreciation2,0003,2001,9201,152Equipment purchases-
$10,000Cash flow due to change in NOWC-$2,400-$72-$74-
$76$2,623Net cash flow due to salvage$991Net Cash Flow
(Time line of cash flows)-
$12,400$4,028$4,605$4,193$7,681Key Results: Appraisal of
the Proposed ProjectNet Present Value (at 10%) =$3,463IRR
=21.09%MIRR =16.99%Payback = 2.90Discounted Payback =
3.23Data for Payback YearsYears01234Net cash flow-
$12,400$4,028$4,605$4,193$7,681Cumulative CF -$12,400-
$8,372-$3,767$425$8,106Part of year required for
payback1.001.000.900.00Data for Discounted Payback
YearsYears01234Net cash flow-

4. $12,400$4,028$4,605$4,193$7,681Discounted cash flow-
$12,400$3,662$3,806$3,150$5,246Cumulative CF -$12,400-
$8,738-$4,933-$1,783$3,463Part of year required for discounted
payback1.001.001.000.23b. Now conduct a sensitivity analysis
to determine the sensitivity of NPV to changes in the sales
price, variable costs per unit, and number of units sold. Set
these variables’ values at 10% and 20% above and below their
base-case values. Include a graph in your analysis.%
DeviationSALES PRICENote about data tables. The data in the
column input should NOT be input using a cell reference to the
column input cell. For example, the base case Sales Price in
Cell B95 should be the number $24.00 you should NOT have the
formula =D28 in that cell. This is because you'll use D28 as the
column input cell in the data table and if Excel tries to
iteratively replace Cell D28 with the formula =D28 rather than a
series of numbers, Excel will calculate the wrong answer.
Unfortunately, Excel won't tell you that there is a problem, so
you'll just get the wrong values for the data
table!fromBaseNPVBase Case$24.00$3,463-20%$19.20-$5,893-
10%$21.60-
$1,2150%$24.00$3,46310%$26.40$8,14120%$28.80$12,820%
DeviationVARIABLE COST% Deviation1st YEAR UNIT
SALESfromBaseNPVfromBaseNPVBase Case$17.50$3,463Base
Case1,000$3,463-20%$14.00$10,401-20%800$1,045-
10%$15.75$6,932-

5. 10%900$2,2540%$17.50$3,4630%1,000$3,46310%$19.25-
$610%1,100$4,67320%$21.00-
$3,47520%1,200$5,882DeviationNPV at Different Deviations
from BasefromSalesVariableBase CasePriceCost/UnitUnits
Sold-20%-$5,893$10,401$1,045-10%-
$1,215$6,932$2,2540%$3,463$3,463$3,46310%$8,141-
$6$4,67320%$12,820-
$3,475$5,882Range$18,712$13,876$4,837c. Now conduct a
scenario analysis. Assume that there is a 25% probability that
best-case conditions, with each of the variables discussed in
Part b being 20% better than its base-case value, will occur.
There is a 25% probability of worst-case conditions, with the
variables 20% worse than base, and a 50% probability of base-
case
conditions.SalesUnitVariableScenarioProbabilityPriceSalesCost
sNPVBest Case25%$28.801,200$14.00$25,435Base
Case50%$24.001,000$17.50$3,463 Worst Case
25%$19.20800$21.00($11,990)Expected NPV =$5,093Standard
Deviation = $13,332Coefficient of Variation = Std Dev /
Expected NPV =2.62d. If the project appears to be more or less
risky than an average project, find its risk-adjusted NPV, IRR,
and payback.CV range of firm's average-risk
project:0.8to1.2Low-risk WACC =8%WACC =10%High-risk
WACC =13%Risk-adjusted WACC =13%Risk adjusted NPV
=$2,387IRR =21.09%

6. Kenneth D. Jackson: IRR does not change.
Payback =2.90
Kenneth D. Jackson: Paypack does not change.
e. On the basis of information in the problem, would you
recommend that the project be accepted?At this point, the
project looks risky but acceptable. There is a good chance that
it will produce a positive NPV, but there is also a chance that
the NPV could be quite low.The problem gave no information
about the size of the project relative to the total corporation. If
the company were quite large, and this were but one of many
projects, and if the projects were independent of one another,
then it should be accepted. However, if the firm were relatively
small, and this project under bad conditions could bankrupt the
company, then the decision is not clear. If management is
highly risk averse, they might turn it down. However, well-
diversified investors would probably prefer to see it accepted.
So, to maximize the stock price, it should be accepted.We
indicate in the problem that this project's returns will tend to be
highly correlated with the firm's other projects' returns. Thus,
its stand-alone risk (which is what we have been analyzing) also
reflects its within-firm risk. If this were not true, then we
would need to make further risk adjustments.
Sensitivity Analysis

7. Sales price-0.2-0.100.10.2-5892.876254354208-
1214.76951847552123463.33721740317748141.4439532818797
12819.550689160566VC-0.2-
0.100.10.210401.2073765453136932.27229697424633463.3372
174031774-5.5978621678877971-3474.5329417389548Units-
0.2-
0.100.10.21044.99390478791972254.16556109554953463.3372
1740317744672.50887371080535881.6805300184315
Percentage Deviation from Base
NPV ($)
Scenario SummaryScenario SummaryCurrent
Values:BaseBestWorstCreated by Michael C. Ehrhardt on
11/13/2001Created by Michael C. Ehrhardt on 11/13/2001
Modified by Michael C. Ehrhardt on 11/13/2001Created by
Michael C. Ehrhardt on 11/13/2001Changing
Cells:$D$291,0001,0001,200800$D$30$24.00$24.00$28.80$19.
20$D$31$17.50$17.50$14.00$21.00Result
Cells:$D$79$3,463$3,463$25,435($11,990)$D$8021.09%21.09
%76.96%ERROR:#NUM!$D$8116.99%16.99%43.42%-
41.46%Notes: Current Values column represents values of
changing cells attime Scenario Summary Report was created.
Changing cells for eachscenario are highlighted in gray.