adms1000 Lecture Notes - Lecture 4: Net Present Value

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10 Oct 2017

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Kellycam inc. is thinking of buying a new kellycam machine. The initial cost of the machine is m, and the machine is good for ten years, at which time it can be sold for ,000. The annual cash flows are either ,000 or ,000 per year, each event occurring with a 50% probability. 5*[-1m + pv(pmt=150k,n=10,r=. 15, fv = 100k) (. 5*279,410) + (. 5*-222,467) = 28,471: now we add a bit. The firm has the option at the end of the first year to abandon the project based on the cash flows achieved during the first year. It will have the same annual cash flows in the last nine years of the proje(cid:272)t that it has in the first year, if it doesn"t a(cid:271)andon the proje(cid:272)t. If it does abandon the project, it will be able to sell the kellycam machine at that time for. Npv of abandon for ,000k branch = -1m +150,000/1. 15 + 850,000/1. 15 = -130,435.

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MandelMandel

âManufacturing, Inc. has a manufacturing machine that needsattention. The company is considering two options. Option 1 is torefurbish the current machine at a cost of $ 2,000,000. Ifârefurbished, Mandel expects the machine to last another 88 yearsand then have no residual value. Option 2 is to replace the machineat a cost of $4,200,000. A new machine would last 1010 years andhave no residual value. Mandel expects the following net cashinflows from the twoâ options:

Year	Refurbish Current	Purchase New
	Machine	Machine
1	$1,300,000	$3,840,000
2	450,000	530,000
3	340,000	420,000
4	230,000	310,000
5	120,000	200,000
6	120,000	200,000
7	120,000	200,000
8	120,000	200,000
9		200,000
10		200,000
Total	$2,800,000	$6,300,000

Compute the payback for both options. Begin by completing thepayback schedule for Option 1â (refurbish).

	Save Accounting Table...		+
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	Net Cash Outflows	Net Cash Inflows
Year	Amount Invested	Annual	Accumulated
0	$2,000,000
1
2
3
4
5
6
7
8

â(Round your answer to one decimalâ place.)

	Save Accounting Table...		+
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Now complete the payback schedule for Option 2â (purchase).

	Save Accounting Table...		+
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	Net Cash Outflows	Net Cash Inflows
Year	Amount Invested	Annual	Accumulated
0	$4,200,000
1
2
3
4
5
6
7
8
9
10

â(Round your answer to one decimalâ place.)

	Save Accounting Table...		+
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Compute the ARRâ (accounting rate ofâ return) for each of theoptions.

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	/	=	ARR
Refurbish	/	=		%
Purchase	/	=		%

Compute the NPV for each of the options. Begin with Option 1â(refurbish). â(Enter the factors to three decimal places. X.XXX.Use parentheses or a minus sign for a negative net presentâvalue.)

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		Net Cash	PV Factor	Present
Years		Inflow	(i = 14%)	Value
	Present value of each year's inflow:
1	(n = 1)
2	(n = 2)
3	(n = 3)
4	(n = 4)
5	(n = 5)
6	(n = 6)
7	(n = 7)
8	(n = 8)
	Total PV of cash inflows
0	Initial investment
	Net present value of the project

Now compute the NPV for Option 2â (purchase). â(Enter thefactors to three decimal places. X.XXX. Use parentheses or a minussign for a negative net presentâ value.)

	Save Accounting Table...		+
	Copy to Clipboard...		+

		Net Cash	PV Factor	Present
Years		Inflow	(i = 14%)	Value
	Present value of each year's inflow:
1	(n = 1)
2	(n = 2)
3	(n = 3)
4	(n = 4)
5	(n = 5)
6	(n = 6)
7	(n = 7)
8	(n = 8)
9	(n = 9)
10	(n = 10)
	Total PV of cash inflows
0	Initial investment
	Net present value of the project

Finally, compute the profitability index for each option.â(Round to two decimal placesâ X.XX.)

	Save Accounting Table...		+
	Copy to Clipboard...		+

	/	=	Profitability index
Refurbish	/	=
Purchase	/	=

ultramarineferret614

In November of 2006, Toyota completed the building of its truck assembly plant in San Antonio, Texas. Unfortunately, in the rush to meet construction deadlines, Toyota instructed the general contractor to not install air conditioning (A/C) in the main facility. But now the time has come for Toyota to finish the facility with the installation of A/C. Toyota's contractor has developed two alternative plans (they are mutually exclusive) for the company to consider:

Plan 1: This A/C investment would require an initial outlay of $600,000 with the following end of year net cash flows: Year 1: -$50,000; Year 2: -$50,000; Year 3: -$50,000; Year 4: -$50,000, Year 5: -$50,000.

Plan 2: This alternative plan would require a smaller initial outlay but higher yearly operating costs. The initial outlay would be $100,000 and end of year net cash flows are estimated to be: Year 1: -$175,000; Year 2: -$175,000; Year 3: -$175,000, Year 4: -$175,000; Year 5: -$175,000.

Question 1: Calculate the NPV for each plan. Assume that Toyota's WACC is 7%. Use a financial calculator to answer this question and show your keystrokes. Check figures for Plan 1: Keystrokes using the HP12C NPV keys are CF0 = -$600,000, CFj = -$50,000, Nj = 5, i = 7, so NPV for plan 1 is -$805,009.87; or using TVM keys (n=5, i=7, PV=?, PMT=-$50,000, FV=0) = -$205,009.87 plus -$600,000 = -$805,009.87.

Question 2: For mutually exclusive projects, normally the rule is to accept only the project or plan with the highest positive NPV. However, Toyota is faced with a mandatory decision to accept either plan 1 or 2, neither of which generates positive net cash flows. Which plan should Toyota accept? Explain why.

Question 3: Explain why the IRR of either plan cannot be determined.

chocolatescorpion584

Real Options

The assignment is to evaluate both parts, the traditional NPVcalculation as well as the Real Options approach.

Scenario: A company must decide whether to invest $100 millionin developing and implementing a new enterprise system in the faceof considerable technological and market (demand for product andmarket share) uncertainty. The firm's cost of capital is 10%.

Part 1.â¨

The probability of a successful project (or pilot) is now .7 andthe probability of an unsuccessful project is .3.

Good Result: The Free Cash flow perpetuity (Annual Benefits) inthe âgoodâ case is $15 million per year

Bad Result: The system proves to be more difficult to implementand improvements in management of the supply chain are less. Inaddition, the growth in market demand for the product is lower. TheFree Cash flow perpetuity (Annual Benefits) in the "bad" case isnow $1.5 million per year, not $2 million.

Given: Year 0 (now) cash flows: $-100 million for ERP purchaseand implementation.

The cost of capital is .1. Use this to calculate the PV of theâgoodâ perpetuity and the PV of the âbadâ perpetuity. Thencalculate the âgoodâ NPV and the âbadâ NPV. Finally calculate theExpected NPV and decide if you will invest.

Part 2.â¨

The real options alternative allows for flexibility and thedelay of the investment for 1 year. In this case, if we do a pilotproject we will be better able to evaluate ERP implementationcomplexities, achievable supply chain benefits, and the marketshare our products will achieve. However, the cost of the projectwill rise to $110 Million ($10 Million this year and $100 Millionnext year) with the one-year delay and additionally managementdecides to purchase and implement the financial module in year 1 ata cost of $10 Million (real option).

The results are slightly different:

Year 0 (now) cash flows: $10 million for the pilot project.

After year 1, if the conditions indicate a good result, the firmwill invest the $100 million for the ERP with expected benefits(cash flows) of $15 million annually (forever) beginning in year 2.Benefits in year one from the financial module are $1 million.

If a bad result is indicated, the firm makes no furtherinvestments beyond the financial module, which yield annualbenefits of $.5 million in year 1 and each year thereafter(forever).

Here the firm has flexibility and has exercised its option tomake no further investments based on better information andknowledge of expected future benefits.

Evaluate the expected NPV of this project using the describedreal option.

Consider that we have the opportunity to do a pilot program byinstalling the financial model only at a cost of $10 MM. A yearfrom now, we can decide whether to invest in the full plant or not.Analyze this case as follows: Find the good case NPV and the badcase NPV. Obviously, we won't exercise the option if we discoverthat we're in the Bad Case. So, we limit our loss to $10 MM lessthe present value of the bad case starting in Year 1.

Part 3.â¨

What is the expected NPV in each case? Compare the

expected NPV using the traditional NPV approach with theexpected NPV using real options. What do you recommend? Why? Whatdo you conclude in each case?

If you don't know the probability of success for the pilot, isthere a value that is critical to your recommendation? Is there aprobability of success above or below which you will recommendundertaking the pilot and below or above which you will recommend ago/ no go decision on the underlying project without undertaking apilot test? â¨â¨

Label your work as follows:

Part 1: NPV Analysisâ¨

1. PV of "Good" perpetuity:â¨

2. PV of "Bad" perpetuityâ¨

3. "Good" NPV:â¨

4. "Bad" NPV:â¨

5. Expected NPV: â¨

6. Invest or don't invest:

Part 2: Real Options Approachâ¨

1. Good case NPV by installing the financial module.â¨

2. Bad case NPV by installing the financial module.â¨

3. Expected NPV by installing the financial module.â¨

4. Should we go ahead with the financial module pilot project orthe full project? â¨

5. Should we undertake both the full project and the pilot"today"?

Part 3: Critical Probabilitiesâ¨

1. Probability to forget the Pilot and complete the Project. Wecan find that probability by equating the present values of thefull project and thepilot. â¨

2. Probability of going ahead with the Pilot. We can calculatethe critical probability for going ahead with the pilot by settingthe PV expression = 0 and solving for X.â¨

3. If there is no real option, breakeven probability for go/nogo.â¨

adms1000 Lecture Notes - Lecture 4: Net Present Value

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