AnswerstoEnd-of-ChapterProblemsB-AnswerstoEnd-of-ChapterProblemsB-PAGE97B-PAGEB-PAGE96AnswerstoEnd-of-ChapterProblemsChapter8:StrategyandAnalysisinUsingNetPresentValueConceptQuestions-Chapter8 WhatarethewaysafirmcancreatepositiveNPV.Befirsttointroduceanewproduct.Furtherdevelopacorecompetencytoproductgoodsorservicesatlowerthancompetitors.Createabarrierthatmakesitdifficultfortheotherfirmstoeffectively.IntroducevariationonexistingproductstotakeadvantageofunsatisfieddemandCreateproductdifferentiationbyaggressiveadvertisingandmarketingnetworks.Useinnovationinorganizationalprocessestodoalloftheabove.Howcanmanagersusethemarkettohelpthemscreenoutnegativeprojects?Whatisadecisiontree?Itisamethodtohelpcapitalbudgetingdecision-makersevaluatingprojectsinvolvingsequentialdecisions.Ateverypointinthetree,therearedifferentalternativesthatshouldbeanalyzed.Whatarepotentialproblemsinusingadecisiontree?Potentialproblems1)thatadifferentdiscountrateshouldbeusedfordifferentbranchesinthetreeand2)itisdifficultfordecisiontreestocapturemanagerialoptions. Whatisasensitivityanalysis?Itisatechniqueusedtodeterminehowtheresultofadecisionchangeswhensomeoftheparametersorassumptionschange.Whyisitimportanttoperformasensitivityanalysis?Becauseitprovidesananalysisoftheconsequencesofpossiblepredictionorassumptionerrors.Whatisabreak-evenanalysis?Itisatechniqueusedtodeterminethevolumeofproductionnecessarytobreakeven,thatis,tocovernotonlyvariablecostsbutfixedcostsaswell.Describehowsensitivityanalysisinteractswithbreak-evenanalysis.Sensitivityanalysiscandeterminehowthefinancialbreak-evenpointwhensomefactors(suchasfixedcosts,variablecosts,orrevenue)change.AnswerstoEnd-of-ChapterProblemsQUESTIONSANDPROBLEMSDecisionTrees8.1SonyElectronics,Inc.,hasdevelopedanewtypeofVCR.Ifthefirmdirectlygoestothemarketwiththeproduct,thereisonlya50percentchanceofsuccess.Ontheotherhand,ifthefirmconductstestmarketingoftheVCR,itwilltakeayearandwillcost$2million.Throughthetestmarketing,however,thefirmisabletoimprovetheproductandincreasetheprobabilityofsuccessto75percent.Ifthenewproductprovessuccessful,thepresentvalue(atthetimewhenthefirmstartssellingit)ofthepayoffis$20million,whileifitturnsouttobeafailure,thepresentvalueofthepayoffis$5million.Shouldthefirmconducttestmarketingorgodirectlytothemarket?Theappropriatediscountrateis15percent.Godirectly:NPV=0.5$20million+0.5$5million=$12.5millionTestmarketing:NPV=-$2million+(0.75$20million+0.25$5million)/1.15=$12.13millionGodirectlytothemarket.Themarketingmanagerforagrowingconsumerproductsfirmisconsideringlaunchinganewproduct.Todetermineconsumers’interestinsuchaproduct,themanagercanconductafocusgroupthatwillcost$120,000andhasa70percentchanceofcorrectlypredictingthesuccessoftheproduct,orhireaconsultingfirmthatwillresearchthemarketatacostof$400,000.Theconsultingfirmboastsacorrectassessmentrecordof90percent.Ofcoursegoingdirectlytothemarketwithnopriortestingwillbethecorrectmove50percentofthetime.Ifthefirmlaunchestheproduct,anditisasuccess,thepayoffwillbe$1.2million.Whichactionwillresultinthehighestexpectedpayoffforthefirm?8.2 Focusgroup:-$120,000+0.70$1,200,000=$720,000Consultingfirm:-$400,000+0.90$1,200,000=$680,000Directmarketing:0.50$1,200,000=$600,000Themanagershouldconductafocusgroup.TandemBicyclesisnoticingadeclineinsalesduetotheincreaseoflower-pricedimportproductsfromtheFarEast.TheCFOisconsideringanumberofstrategiestomaintainitsmarketshare.Theoptionssheseesarethefollowing:Pricetheproductsmoreaggressively,resultingina$1.3milliondeclineincashflows.ThelikelihoodthatTandemwilllosenocashflowstotheimportsis55percent;thereisa45percentprobabilitythattheywillloseonly$550,000incashflowstotheimports.Hirealobbyisttoconvincetheregulatorsthatthereshouldbeimportanttariffsplaceduponoverseasmanufacturersofbicycles.ThiswillcostTandem$800,000andwillhavea75percentsuccessrate,thatis,nolossincashflowstotheimporters.Ifthelobbyistsdonotsucceed,TandemBicycleswilllose$2millionincashflows.AstheassistanttotheCFO,whichstrategywouldyourecommendtoyourboss?AccountingBreak-EvenAnalysisPricemoreaggressively:-$1,300,000+(0.550)+0.45(-$550,000)=-$1,547,500Hirelobbyist:-$800,000+(0.750)+0.25(-$2,000,000)=-$1,300,000Tandemshouldhirethelobbyist.SamuelsonInc.hasinvestedinafacilitytoproducecalculators.Thepriceofthemachineis$600,000anditseconomiclifeisfiveyears.Themachineisfullydepreciatedbythestraight-linemethodandwillproduce20,000unitsofcalculatorsinthefirstyear.Thevariableproductioncostperunitofthecalculatoris$15,whilefixedcostsare$900,000.Thecorporatetaxrateforthecompanyis30percent.Whatshouldthesalespriceperunitofthecalculatorbeforthefirmtohaveazeroprofit?Letsalespricebex.Depreciation=$600,000/5=$120,000BEP:($900,000+$120,000)/(x-$15)=20,000x=$66Whatistheminimumnumberofunitsthatadistributorofbig-screenTVsmustsellinagivenperiodtobreakeven?Salesprice_$1,500Variablecosts_$1,100Fixedcosts_$120,000Depreciation_$20,000Taxrate_35%Theaccountingbreak-even=(120,000+20,000)/(1,500-1,100)=350unitsYouareconsideringinvestinginafledglingcompanythatcultivatesabaloneforsaletolocalrestaurants.Theproprietorsayshe’llreturnallprofitstoyouaftercoveringoperatingcostsandhissalary.Howmanyabalonemustbeharvestedandsoldinthefirstyearofoperationsforyoutogetanypayback?(Assumenodepreciation.)Priceperadultabalone_$2.00Variablecosts_$0.72Fixedcosts_$300,000Salaries_$40,000Taxrate_35%Howmuchprofitwillbereturnedtoyouifhesells300,000abalone?a.b.

Theaccountingbreak-even=340,000/(2.00-0.72)=265,625abalones[($2.00300,000)-(340,000+0.72300,000)](0.65)=$28,600Thisistheaftertaxprofit.PresentValueBreak-EvenAnalysisUsingtheinformationintheproblemabove,whatisthepresentvaluebreak-evenpointifthediscountrateis15percent,initialinvestmentis$140,000,andthelifeoftheprojectissevenyears?Assumeastraight-linedepreciationmethodwithazerosalvagevalue.8.7 EAC =$140,000/70.15

=$33,650Depreciation=$140,000/7=$20,000BEP ={$33,650+$340,0000.65-$20,0000.35}/{($2-$0.72)0.65}=297,656.25297,657unitsKids&ToysInc.haspurchaseda$200,000machinetoproducetoycars.Themachinewillbefullydepreciatedbythestraight-linemethodforitseconomiclifeoffiveyearsandwillbeworthlessafteritslife.Thefirmexpectsthatthesalespriceofthetoyis$25whileitsvariablecostis$5.Thefirmshouldalsopay$350,000asfixedcostseachyear.Thecorporatetaxrateforthecompanyis25percent,andtheappropriatediscountrateis12percent.Whatisthepresentvaluebreak-evenpoint?8.8 Depreciation=$200,000/5=$40,000EAC

=$200,000/50.12

=$200,000/3.60478BEP

=$55,482={$55,482+$350,0000.75-$40,0000.25}/{($25-$5)0.75}=20,532.1320533unitsTheCornchopperCompanyisconsideringthepurchaseofanewharvester.Thecompanyiscurrentlyinvolvedindeliberationswiththemanufacturerandthepartieshavenotcometosettlementregardingthefinalpurchaseprice.ThemanagementofCornchopperhashiredyoutodeterminethebreak-evenpurchasepriceoftheharvester.ThispriceisthatwhichwillmaketheNPVoftheprojectzero.Baseyouranalysisonthefollowingfacts:Thenewharvesterisnotexpectedtoaffectrevenues,butoperatingexpenseswillbereducedby$10,000peryearfor10years.Theoldharvesterisnow5yearsold,with10yearsofitsscheduledliferemaining.Itwaspurchasedfor$45,000.Ithasbeendepreciatedonastraight-linebasis.Theoldharvesterhasacurrentmarketvalueof$20,000.Thenewharvesterwillbedepreciatedonastraight-linebasisoverits10-yearlife.Thecorporatetaxrateis34percent.Thefirm’srequiredrateofreturnis15percent.Allcashflowsoccuratyear-end.However,theinitialinvestment,theproceedsfromsellingtheoldharvester,andanytaxeffectswilloccurimmediately.Capitalgainsandlossesaretaxedatthecorporaterateof34percentwhentheyarerealized.Theexpectedmarketvalueofbothharvestersattheendoftheireconomiclivesiszero.8.9

LetIbethebreak-evenpurchaseprice.IncrementalC0Saleoftheoldmachine $20,000Taxeffect 3,400Total $23,400Depreciationperperiod=$45,000/15=$3,000Bookvalueofthemachine=$45,000-5$3,000=$30,000Lossonsaleofmachine=$30,000-$20,000=$10,000Taxcreditduetoloss=$10,0000.34=$3,400Incrementalcostsavings:$10,000(1-0.34)=$6,600Incrementaldepreciationtaxshield:[I/10-$3,000](0.34)Thebreak-evenpurchasepriceistheInvestment(I),whichmakestheNPVbeNPV =0=-I+$23,400+$6,600100.15+[I/10-$3,000](0.34)100.15=-I+$23,400+$6,600(5.0188)+I(0.034)(5.0188)-$3,000(0.34)(5.0188)I=$61,981ScenarioAnalysisMs.Thompson,astheCFOofaclockmaker,isconsideringaninvestmentofa$420,000machinethathasaseven-yearlifeandnosalvagevalue.Themachineisdepreciatedbyastraight-linemethodwithazerosalvageoverthesevenyears.Theappropriatediscountrateforcashflowsoftheprojectis13percent,andthecorporatetaxrateofthecompanyis35percent.CalculatetheNPVoftheprojectinthefollowingscenario.Whatisyourconclusionabouttheproject?PessimisticExpectedOptimisticUnitsales23,00025,00027,000Price$38$40$42Variablecosts$21$20$19Fixedcosts$320,000$300,000$280,000Pessimistic:NPV =-$420,000

723,000$38$21$320,0000.65$60,0000.35Expected:

t1=-$123,021.71

1.13tNPV

=-$420,000+=$247,814.17

7t

25,000$40$20$300,0000.65$60,0000.351.13tOptimistic:

7NPV =-$420,000+

27,000$42$19$280,0000.65$60,0000.35=$653,146.42

t1

1.13tEventhoughtheNPVofpessimisticcaseisnegative,ifwechangeoneinputwhileallothersareassumedtomeettheirexpectation,wehaveallpositiveNPVsliketheonebefore.Thus,thisprojectisquiteprofitable.PessimisticNPVUnitsales23,000$132,826.30Price$38$104,079.33Variablecosts$21$175,946.75Fixedcosts$320,000$190,320.24Youarethefinancialanalystforamanufactureroftennisracketsthathasidentifiedagraphite-likematerialthatitisconsideringusinginitsrackets.Giventhefollowinginformationabouttheresultsoflaunchinganewracket,willyouundertaketheproject?(Assumptions:Taxrate_40%,Effectivediscountrate_13%,Depreciation_$300,000peryear,andproductionwilloccuroverthenextfiveyearsonly.)PessimisticExpectedOptimisticMarketsize110,000120,000130,000Marketshare22%25%27%Price$115$120$125Variablecosts$72$70$68Fixedcosts$850,000$800,000$750,000Investment$1,500,000$1,500,000$1,500,000Pessimistic:NPV =-$1,500,0005$72$300,000+Expected:

t1=-$675,701.68

1.13t 5 120,000$70$800,000$300,000+t1=$399,304.88

1.13tOptimistic:NPV =-$1,500,000+5 130,0000.27$125$68$750,0000.60$300,0000.401.13tt1=$1,561,468.43Theexpectedpresentvalueofthenewtennisracketis$428,357.21.(Assumingthereareequalchancesofthe3scenariosoccurring.)Whatwouldhappentotheanalysisdoneaboveifyourcompetitorintroducesagraphitecompositethatisevenlighterthanyourproduct?Whatfactorswouldthislikelyaffect?DoanNPVanalysisassumingmarketsizeincreases(duetomoreawarenessofgraphite-basedrackets)tothelevelpredictedbytheoptimisticscenariobutyourmarketsharedecreasestothepessimisticlevel(duetocompetitiveforces).Whatdoesthistellyouabouttherelativeimportanceofmarketsizeversusmarketshare?5 8.12 NPV=1,500,000=$251,581.17

t1

1.13tThe3%dropinmarketsharehurtsignificantlymorethanthe10,000increaseinmarketsizehelped.However,ifthedropwereonly2%,theeffectswouldbeabouteven.Marketsizeisgoingupbyover8%,thusitseemsmarketshareismoreimportantthanmarketTheOptiontoAbandonYouhavebeenhiredasafinancialanalysttodoafeasibilitystudyofanewvideogameforPassivision.MarketingresearchsuggestsPassivisioncansell12,000unitsperyearat$62.50netcashflowperunitforthenext10year