Build A Model Solution Chapter 11 Estimating Cash Flows

Build A Modelsolution81315chapter11estimating Cash Flows And Analyz

Build a spreadsheet model to evaluate the project's cash flows, and calculate the net present value (NPV), internal rate of return (IRR), and payback period for a new server project. Assess the project's sensitivity by analyzing how changes in sales price, variable costs, and units sold affect NPV. Conduct a scenario analysis considering different market conditions and probabilities. Adjust project risk measures using different WACC values based on risk levels. Finally, analyze whether to accept or reject the project based on these evaluations, providing well-justified conclusions supported by financial metrics.

Sample Paper For Above instruction

Introduction

The decision to undertake a capital project hinges on comprehensive financial analysis, which includes estimating cash flows, assessing risk, and calculating valuation metrics such as NPV and IRR. The project under consideration involves purchasing and operating a new server for Webmasters.com, with the goal of generating revenue through unit sales over a four-year period. A methodical approach to modeling, sensitivity analysis, scenario planning, and risk adjustment informs whether the project aligns with the firm’s strategic and financial objectives.

Project Overview and Data Assumptions

The project requires an initial investment of $10 million for equipment, depreciated over five years using MACRS rates. Annual revenues derive from selling 1,000 units at $24,000 each, with subsequent inflation adjustments of 3%. Variable costs are $17,500 per unit, and non-variable operating costs start at $1 million in Year 1, inflating with market prices. Working capital is set at 10% of annual sales, necessitating an initial investment and adjustments throughout the project’s life. Residual value of the equipment is projected at $500,000 at Year 4.

The firm’s tax rate is 40%, and the project’s risk profile warrants using a 10% WACC, aligned with the firm’s average risk level. The project’s cash flows will be analyzed to determine NPV, IRR, payback period, and other relevant metrics.

Model Development and Calculation of Cash Flows

The first step involves constructing a detailed financial spreadsheet that estimates each year’s revenue, expenses, and after-tax cash flows. Revenue calculations consider units sold multiplied by the selling price, increasing at inflation each year. Variable costs per unit also inflate accordingly.

Depreciation is calculated using MACRS rates over five years, with the initial cost basis of $10 million. The annual depreciation expenses are deducted from EBIT to determine taxable income, leading to taxes at the 40% rate. The after-tax operating cash flow is obtained by adding back depreciation to net income.

Changes in net working capital (NWC) are estimated based on sales projections, affecting the initial investment and annual cash flows. The residual salvage value of $500,000, less taxes on any gain, is included in the final year cash flow. All cash flow components are discounted at the selected WACC to derive the project's NPV.

NPV, IRR, and Payback Analyses

Applying the discounting process, the model computes the present value of all cash inflows and outflows, resulting in an NPV. An IRR calculation identifies the discount rate at which the NPV equals zero. The payback period measures the time required for cumulative cash flows to recover initial investments without discounting, while the discounted payback considers the time value of money.

These metrics provide a comprehensive view of the project’s profitability and liquidity risk. A positive NPV, an IRR exceeding the WACC, and a reasonable payback period support project acceptance, provided the risk assessment aligns with the firm's criteria.

Sensitivity and Scenario Analyses

Sensitivity analysis involves adjusting key variables—sales price, variable costs, and units sold—by ±10% and ±20%. Each variation’s effect on NPV is calculated and visualized via a graph, highlighting the most influential factors on project viability.

Scenario analysis considers three situations: best-case (high sales and prices), worst-case (lower sales and higher costs), and base-case. Probabilities are assigned: 25% each for best and worst cases, and 50% for the base case. By calculating expected NPV and its standard deviation, the project’s risk profile is quantitatively assessed.

Risk Adjustment and WACC Selection

Based on the risk analysis, the project’s coefficient of variation (CV) in NPV guides WACC adjustments: low risk warrants 8%, average risk 10%, and high risk 13%. The project’s risk-adjusted metrics—NPV, IRR, and payback—are calculated using the appropriate WACC, providing a more accurate valuation aligned with the project's risk profile.

Conclusion and Investment Decision

Integrating the results from the financial metrics, sensitivity, scenario, and risk adjustments, a decision rule is applied. If the NPV is positive at the risk-adjusted WACC, and the IRR exceeds this rate, the project is financially viable. Considerations of payback period and strategic fit support the final recommendation.

In this case, assuming the calculated NPV remains positive after all adjustments, and IRR exceeds the prevailing WACC, the project would be recommended for acceptance. Conversely, if the metrics indicate risk outweighs potential returns, rejection would be prudent.

References

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- Investopedia. (2023). Cost of Capital. Retrieved from https://www.investopedia.com/terms/c/costofcapital.asp