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www.downloadslide.net EssEntials 9e of Corporate Finance Ross Westerfeld Jordan www.downloadslide.net Essentials of Corporate Finance i www.downloadslide.net The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A Ross, Consulting Editor Franco Modigliani Professor of Finance and Economics Sloan School of Management, Massachusetts Institute of Technology FINANCIAL MANAGEMENT Block, Hirt, and Danielsen Foundations of Financial Management Sixteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance Twelfth Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Eighth Edition Brooks FinGame Online 5.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Seventh Edition Cornett, Adair, and Nofsinger Finance: Applications and Theory Third Edition Cornett, Adair, and Nofsinger M: Finance Third Edition DeMello Cases in Finance Second Edition Grinblatt (editor) Stephen A Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Higgins Analysis for Financial Management Eleventh Edition Kellison Theory of Interest Third Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance Eleventh Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fourth Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Ninth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eleventh Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition White Financial Analysis with an Electronic Calculator Sixth Edition INVESTMENTS Bodie, Kane, and Marcus Essentials of Investments Tenth Edition Bodie, Kane, and Marcus Investments Tenth Edition Hirt and Block Fundamentals of Investment Management Tenth Edition Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Seventh Edition Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition Sundaram and Das Derivatives: Principles and Practice Second Edition FINANCIAL INSTITUTIONS AND MARKETS Rose and Hudgins Bank Management and Financial Services Ninth Edition Rose and Marquis Financial Institutions and Markets Eleventh Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Eighth Edition Saunders and Cornett Financial Markets and Institutions Sixth Edition INTERNATIONAL FINANCE Eun and Resnick International Financial Management Seventh Edition REAL ESTATE Brueggeman and Fisher Real Estate Finance and Investments Fifteenth Edition Ling and Archer Real Estate Principles: A Value Approach Fourth Edition FINANCIAL PLANNING AND INSURANCE Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Eleventh Edition Altfest Personal Financial Planning Second Edition Harrington and Niehaus Risk Management and Insurance Second Edition Kapoor, Dlabay, Hughes, and Hart Focus on Personal Finance: An active approach to help you achieve financial literacy Fifth Edition Kapoor, Dlabay, Hughes, and Hart Personal Finance Eleventh Edition Walker and Walker Personal Finance: Building Your Future First Edition www.downloadslide.net Essentials of Corporate Finance Ninth Edition Stephen A Ross Massachusetts Institute of Technology Randolph W Westerfield University of Southern California Bradford D Jordan University of Kentucky www.downloadslide.net ESSENTIALS OF CORPORATE FINANCE, NINTH EDITION Published by McGraw-Hill Education, Penn Plaza, New York, NY 10121 Copyright © 2017 by McGraw-Hill Education All rights reserved Printed in the United States of America Previous editions © 2014, 2011, 2008, and 2007 No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning Some ancillaries, including electronic and print components, may not be available to customers outside the United States This book is printed on acid-free paper DOW/DOW ISBN 978-1-259-27721-4 MHID 1-259-27721-6 Senior Vice President, Products & Markets: Kurt L Strand Vice President, General Manager, Products & Markets: Marty Lange Vice President, Content Design & Delivery: Kimberly Meriwether David Managing Director: James Heine Brand Manager: Charles Synovec Director, Product Development: Rose Koos Lead Product Developer: Michele Janicek Product Developer: Jennifer Upton Marketing Manager: Melissa Caughlin Director of Digital Content Development: Douglas Ruby Digital Product Developer: Tobi Philips Digital Product Analyst: Kevin Shanahan Director, Content Design & Delivery: Linda Avenarius Program Manager: Mark Christianson Content Project Managers: Kathryn D Wright, Bruce Gin, and Karen Jozefowicz Buyer: Sandy Ludovissy Design: Matt Diamond Content Licensing Specialist: Beth Thole Cover Image: © Philippe Intraligi/Getty Images Compositor: Aptara®, Inc Printer: R R Donnelley All credits appearing on page or at the end of the book are considered to be an extension of the copyright page Library of Congress Cataloging-in-Publication Data Names: Ross, Stephen A., author | Westerfield, Randolph W., author | Jordan, Bradford D., author Title: Essentials of corporate finance / Stephen A Ross, Massachusetts Institute of Technology, Randolph W Westerfield, University of Southern California, Bradford D Jordan, University of Kentucky Description: Ninth edition | New York, NY : McGraw-Hill/Irwin, [2015] Identifiers: LCCN 2015046933 | ISBN 9781259277214 (alk paper) | ISBN 1259277216 (alk paper) Subjects: LCSH: Corporations Finance Classification: LCC HG4026 R676 2015 | DDC 658.15 dc23 LC record available at http://lccn.loc.gov/2015046933 The Internet addresses listed in the text were accurate at the time of publication The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites mheducation.com/highered www.downloadslide.net About the Authors Stephen A Ross Sloan School of Management, Franco Modigliani Professor of Financial Economics, Massachusetts Institute of Technology Stephen A Ross is the Franco Modigliani Professor of Financial Economics at the Sloan School of Management, Massachusetts Institute of Technology One of the most widely published authors in finance and economics, Professor Ross is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signaling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics A past president of the American Finance Association, he currently serves as an associate editor of several academic and practitioner journals He is a trustee of CalTech Randolph W Westerfield Marshall School of Business, University of Southern California Randolph W Westerfield is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B Thornton Professor of Finance Emeritus He came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years He is a member of the Board of Trustees of Oaktree Capital Management His areas of expertise include corporate financial policy, investment management, and stock market price behavior Bradford D Jordan Gatton College of Business and Economics, University of Kentucky Bradford D Jordan is Professor of Finance and holder of the Richard W and Janis H Furst Endowed Chair in Finance at the University of Kentucky He has a long-standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy Professor Jordan has published numerous articles on issues such as the cost of capital, capital structure, and the behavior of security prices He is a past president of the Southern Finance Association, and he is coauthor of Fundamentals of Investments: Valuation and Management, 7th edition, a leading investments text, also published by McGraw-Hill Education v www.downloadslide.net From the Authors W hen we first wrote Essentials of Corporate Finance, we thought there might be a small niche for a briefer book that really focused on what students with widely varying backgrounds and interests needed to carry away from an introductory finance course We were wrong There was a huge niche! What we learned is that our text closely matches the needs of instructors and faculty at hundreds of schools across the country As a result, the growth we have experienced through the first eight editions of Essentials has far exceeded anything we thought possible With the ninth edition of Essentials of Corporate Finance, we have continued to refine our focus on our target audience, which is the undergraduate student taking a core course in business or corporate finance This can be a tough course to teach One reason is that the class is usually required of all business students, so it is not uncommon for a majority of the students to be nonfinance majors In fact, this may be the only finance course many of them will ever have With this in mind, our goal in Essentials is to convey the most important concepts and principles at a level that is approachable for the widest possible audience To achieve our goal, we have worked to distill the subject down to its bare essentials (hence, the name of this book), while retaining a decidedly modern approach to finance We have always maintained that the subject of corporate finance can be viewed as the workings of a few very powerful intuitions We also think that understanding the “why” is just as important, if not more so, than understanding the “how”—especially in an introductory course Based on the gratifying market feedback we have received from our previous editions, as well as from our other text, Fundamentals of Corporate Finance (now in its eleventh edition), many of you agree By design, this book is not encyclopedic As the table of contents indicates, we have a total of 18 chapters Chapter length is about 30 pages, so the text is aimed squarely at a single-term course, and most of the book can be realistically covered in a typical semester or quarter Writing a book for a one-term course necessarily means some picking and choosing, with regard to both topics and depth of coverage Throughout, we strike a balance by introducing and covering the essentials (there’s that word again!) while leaving some more specialized topics to follow-up courses The other things we have always stressed, and have continued to improve with this edition, are readability and pedagogy Essentials is written in a relaxed, conversational style that invites the students to join in the learning process rather than being a passive information absorber We have found that this approach dramatically increases students’ willingness to read and learn on their own Between larger and larger class sizes and the ever-growing demands on faculty time, we think this is an essential (!) feature for a text in an introductory course Throughout the development of this book, we have continued to take a hard look at what is truly relevant and useful In doing so, we have worked to downplay purely theoretical issues and minimize the use of extensive and elaborate calculations to illustrate points that are either intuitively obvious or of limited practical use vi www.downloadslide.net As a result of this process, three basic themes emerge as our central focus in writing Essentials of Corporate Finance: An Emphasis on Intuition We always try to separate and explain the principles at work on a commonsense, intuitive level before launching into any specifics The underlying ideas are discussed first in very general terms and then by way of examples that illustrate in more concrete terms how a financial manager might proceed in a given situation A Unified Valuation Approach We treat net present value (NPV) as the basic concept underlying corporate finance Many texts stop well short of consistently integrating this important principle The most basic and important notion, that NPV represents the excess of market value over cost, often is lost in an overly mechanical approach that emphasizes computation at the expense of comprehension In contrast, every subject we cover is firmly rooted in valuation, and care is taken throughout to explain how particular decisions have valuation effects A Managerial Focus Students shouldn’t lose sight of the fact that financial management concerns management We emphasize the role of the financial manager as decision maker, and we stress the need for managerial input and judgment We consciously avoid “black box” approaches to finance, and, where appropriate, the approximate, pragmatic nature of financial analysis is made explicit, possible pitfalls are described, and limitations are discussed Today, as we prepare to once again enter the market, our goal is to stick with and build on the principles that have brought us this far However, based on an enormous amount of feedback we have received from you and your colleagues, we have made this edition and its package even more flexible than previous editions We offer flexibility in coverage and pedagogy by providing a wide variety of features in the book to help students learn about corporate finance We also provide flexibility in package options by offering the most extensive collection of teaching, learning, and technology aids of any corporate finance text Whether you use just the textbook, or the book in conjunction with other products, we believe you will find a combination with this edition that will meet your needs Stephen A Ross Randolph W Westerfield Bradford D Jordan vii www.downloadslide.net Organization of the Text W e designed Essentials of Corporate Finance to be as flexible and modular as possible There are a total of nine parts, and, in broad terms, the instructor is free to decide the particular sequence Further, within each part, the first chapter generally contains an overview and survey Thus, when time is limited, subsequent chapters can be omitted Finally, the sections placed early in each chapter are generally the most important, and later sections frequently can be omitted without loss of continuity For these reasons, the instructor has great control over the topics covered, the sequence in which they are covered, and the depth of coverage Just to get an idea of the breadth of coverage in the ninth edition of Essentials, the following grid presents for each chapter some of the most significant new features, as well as a few selected chapter highlights Of course, in every chapter, figures, opening vignettes, boxed features, and in-chapter illustrations and examples using real companies have been thoroughly updated as well In addition, the end-of-chapter material has been completely revised Chapters Selected Topics Benefits to Users PART ONE Overview of Financial Management Chapter New opener discussing The Men’s Wearhouse Updated Finance Matters box on corporate ethics Describes ethical issues in the context of mortgage fraud, offshoring, and tax havens Updated information on executive and celebrity compensation Highlights important development regarding the very current question of appropriate executive compensation Updated Work the Web box on stock quotes Goal of the firm and agency problems Stresses value creation as the most fundamental aspect of management and describes agency issues that can arise Ethics, financial management, and executive compensation Brings in real-world issues concerning conflicts of interest and current controversies surrounding ethical conduct and management pay New proxy fight example involving Starboard Value and Darden Restaurants New takeover battle discussion involving Jos A Bank and The Men’s Wearhouse PART TWO Understanding Financial Statements and Cash Flow Chapter New opener discussing large energy company write-offs due to falling oil prices viii Cash flow vs earnings Clearly defines cash flow and spells out the differences between cash flow and earnings Market values vs book values Emphasizes the relevance of market values over book values Updated Work the Web box on SEC filings Discusses the information that public companies are required to file with the SEC, and how to find that information www.downloadslide.net Chapters Selected Topics Benefits to Users Chapter Additional explanation of alternative formulas for sustainable and internal growth rates Expanded explanation of growth rate formulas clears up a common misunderstanding about these formulas and the circumstances under which alternative formulas are correct Updated opener on PE ratios Updated examples on Lowe’s vs Home Depot and Yahoo! vs Google Updated Work the Web box on financial ratios Discusses how to find and analyze profitability ratios PART THREE Valuation of Future Cash Flows Chapter First of two chapters on time value of money Relatively short chapter introduces just the basic ideas on time value of money to get students started on this traditionally difficult topic Updated Finance Matters box on collectibles Chapter Second of two chapters on time value of money Covers more advanced time value topics with numerous examples, calculator tips, and Excel spreadsheet exhibits Contains many real-world examples Updated opener on professional athletes’ salaries Provides a real-world example why it’s important to properly understand how to value costs incurred today versus future cash inflows Updated Work the Web box on student loan payments PART FOUR Valuing Stocks and Bonds Chapter New opener on negative interest on various sovereign bonds Discusses the importance of interest rates and how they relate to bonds Bond valuation Thorough coverage of bond price/yield concepts Updated bond features example using ExxonMobil issue Interest rates and inflation Highly intuitive discussion of inflation, the Fisher effect, and the term structure of interest rates New “fallen angels” example using Petrobas issue “Clean” vs “dirty” bond prices and accrued interest Clears up the pricing of bonds between coupon payment dates and also bond market quoting conventions Updated Treasury quotes exhibit and discussion Updated historic interest rates figure FINRA’s TRACE system and transparency in the corporate bond market Up-to-date discussion of new developments in fixed income with regard to price, volume, and transactions reporting “Make-whole” call provisions Up-to-date discussion of relatively new type of call provision that has become very common Updated Treasury yield curve exhibit ix www.downloadslide.net 294 part Capital Budgeting With this information, we can calculate the net income and cash flows under each scenario (check these for yourself): Scenario Net Income Base case Worst case* Best case $19,800 − 15,510 59,730 Cash Flow Net Present Value $59,800 24,490 99,730 $ 15,566 − 111,719 159,504 IRR 15.1% −14.4 40.9 * We assume a tax credit is created in our worst-case scenario What we learn is that under the worst scenario, the cash flow is still positive at $24,490 That’s good news The bad news is that the return is −14.4 percent in this case, and the NPV is −$111,719 Since the project costs $200,000, we stand to lose a little more than half of the original investment under the worst possible scenario The best case offers an attractive 41 percent return The terms best case and worst case are very commonly used, and we will stick with them, but we should note that they are somewhat misleading The absolute best thing that could happen would be something absurdly unlikely, such as launching a new diet soda and subsequently learning that our (patented) formulation also just happens to cure the common cold Of course, on rare occasions, things go very, very wrong For example, in April 2010, BP’s Gulf of Mexico oil rig Deepwater Horizon caught fire and sank following an explosion, leading to a massive oil spill The leak was finally stopped in July after releasing more than 200 million gallons of crude oil into the Gulf BP’s costs associated with the disaster are expected to exceed $40 billion, perhaps by a wide margin By the middle of 2014, BP had already paid out $28 billion in claims and cleanup costs Then, in September 2014, a federal judge found that BP had violated the Clean Water Act and could be responsible for up to $18 billion in additional penalties Nonetheless, our point is that in assessing the reasonableness of an NPV estimate, we need to stick to cases that are reasonably likely to occur Instead of best and worst, then, it is probably more accurate to say optimistic and pessimistic In broad terms, if we were thinking about a reasonable range for, say, unit sales, then what we call the best case would correspond to something near the upper end of that range The worst case would simply correspond to the lower end As we have mentioned, there are an unlimited number of different scenarios that we could examine At a minimum, we might want to investigate two intermediate cases by going halfway between the base amounts and the extreme amounts This would give us five scenarios in all, including the base case Beyond this point, it is hard to know when to stop As we generate more and more possibilities, we run the risk of “paralysis of analysis.” The difficulty is that no matter how many scenarios we run, all we can learn are possibilities, some good and some bad Beyond that, we don’t get any guidance as to what to Scenario analysis is thus useful in telling us what can happen and in helping us gauge the potential for disaster, but it does not tell us whether or not to take the project sensitivity analysis Investigation of what happens to net present value when only one variable is changed Sensitivity Analysis Sensitivity analysis is a variation on scenario analysis that is useful in pinpointing the areas where forecasting risk is especially severe The basic idea with a sensitivity analysis is to freeze all of the variables except one and then see how sensitive our estimate of NPV is to changes in that one variable If our NPV estimate turns out to be very sensitive to relatively www.downloadslide.net chapter Making Capital Investment Decisions Net present value ($000) f i g u r e 9.1 Sensitivity analysis for unit sales 50 40 NPV $39,357 30 20 NPV $15,566 10 (Worst case) 5,500 –10 (Base case) 6,000 NPV –$8,226 (Best case) Unit sales 6,500 small changes in the projected value of some component of project cash flow, then the forecasting risk associated with that variable is high To illustrate how sensitivity analysis works, we go back to our base case for every item except unit sales We can then calculate cash flow and NPV using the largest and smallest unit sales figures Scenario Base case Worst case Best case Unit Sales Cash Flow 6,000 5,500 6,500 $59,800 53,200 66,400 Net Present Value IRR $15,566 8,226 39,357 15.1% 10.3 19.7 − The results of our sensitivity analysis for unit sales can be illustrated graphically as in Figure 9.1 Here we place NPV on the vertical axis and unit sales on the horizontal axis When we plot the combinations of unit sales versus NPV, we see that all possible combinations fall on a straight line The steeper the resulting line is, the greater is the sensitivity of the estimated NPV to the projected value of the variable being investigated By way of comparison, we now freeze everything except fixed costs and repeat the analysis: Scenario Base case Worst case Best case 295 Fixed Costs Cash Flow Net Present Value IRR $50,000 55,000 45,000 $59,800 56,500 63,100 $15,566 3,670 27,461 15.1% 12.7 17.4 What we see here is that, given our ranges, the estimated NPV of this project is more sensitive to projected unit sales than it is to projected fixed costs In fact, under the worst case for fixed costs, the NPV is still positive As we have illustrated, sensitivity analysis is useful in pinpointing those variables that deserve the most attention If we find that our estimated NPV is especially sensitive to a variable that is difficult to forecast (such as unit sales), then the degree of forecasting risk is high We might decide that further market research would be a good idea in this case www.downloadslide.net 296 part Capital Budgeting Because sensitivity analysis is a form of scenario analysis, it suffers from the same drawbacks Sensitivity analysis is useful for pointing out where forecasting errors will the most damage, but it does not tell us what to about possible errors c o n c e p t q ue stio n s 9.6a What are scenario and sensitivity analyses? 9.6b What are the drawbacks to what-if analyses? 9.7 ADDITIONAL CONSIDERATIONS IN CAPITAL BUDGETING Our final task for this chapter is a brief discussion of two additional considerations in capital budgeting: managerial options and capital rationing Both of these can be very important in practice, but, as we will see, explicitly dealing with either of them is difficult Managerial Options and Capital Budgeting managerial options Opportunities that managers can exploit if certain things happen in the future Also known as “real” options In our capital budgeting analysis thus far, we have more or less ignored the possibility of future managerial actions Implicitly, we have assumed that once a project is launched, its basic features cannot be changed For this reason, we say that our analysis is static (as opposed to dynamic) In reality, depending on what actually happens in the future, there will always be ways to modify a project We will call these opportunities managerial options Because they involve real (as opposed to financial) assets, such options are often called “real” options There are a great number of these options The way a product is priced, manufactured, advertised, and produced can all be changed, and these are just a few of the possibilities We discuss some of the most important managerial options in the next few sections Contingency Planning The various what-if procedures in this chapter have another contingency planning Taking into account the managerial options implicit in a project use We can also view them as primitive ways of exploring the dynamics of a project and investigating managerial options What we think about in this case are some of the possible futures that could come about and what actions we might take if they For example, we might find that a project fails to break even when sales drop below 10,000 units This is a fact that is interesting to know, but the more important thing is to then go on and ask “What actions are we going to take if this actually occurs?” This is called contingency planning, and it amounts to an investigation of some of the managerial options implicit in a project There is no limit to the number of possible futures, or contingencies, that we could investigate However, there are some broad classes, and we consider these next The option to expand One particularly important option we have not explicitly addressed is the option to expand If we truly find a positive NPV project, then there is an obvious consideration: Can we expand the project or repeat it to get an even larger NPV? Our static analysis implicitly assumes that the scale of the project is fixed For example, if the sales demand for a particular product were to greatly exceed expectations, we might investigate increasing production If this were not feasible for some www.downloadslide.net chapter Making Capital Investment Decisions reason, then we could always increase cash flow by raising the price Either way, the potential cash flow is higher than we have indicated because we have implicitly assumed that no expansion or price increase is possible Overall, because we ignore the option to expand in our analysis, we underestimate NPV (all other things being equal) The option to abandon At the other extreme, the option to scale back or even abandon a project is also quite valuable For example, if a project does not even cover its own expenses, we might be better off if we just abandoned it Our DCF analysis implicitly assumes that we would keep operating even in this case In reality, if sales demand were significantly below expectations, we might be able to sell off some capacity or put it to another use Maybe the product or service could be redesigned or otherwise improved Regardless of the specifics, we once again underestimate NPV if we assume that the project must last for some fixed number of years, no matter what happens in the future The option to wait Implicitly, we have treated proposed investments as if they were “go or no-go” decisions Actually, there is a third possibility The project can be postponed, perhaps in hope of more favorable conditions We call this the option to wait For example, suppose an investment costs $120 and has a perpetual cash flow of $10 per year If the discount rate is 10 percent, then the NPV is $10/.10 − 120 = −$20, so the project should not be undertaken now However, this does not mean that we should forget about the project forever, because in the next period, the appropriate discount rate could be different If it fell to, say, percent, then the NPV would be $10/.05 − 120 = $80, and we would take the project More generally, as long as there is some possible future scenario under which a project has a positive NPV, then the option to wait is valuable To illustrate some of these ideas, consider the case of Euro Disney (known today as Disneyland Paris) The deal to open Euro Disney occurred in 1987, and the park opened its doors outside of Paris in 1992 Disney’s management thought Europeans would go goofy over the new park, but trouble soon began The number of visitors never met expectations, in part because the company priced tickets too high Disney also decided not to serve alcohol in a country that was accustomed to wine with meals French labor inspectors fought Disney’s strict dress codes, and so on After several years of operations, the park began serving wine in its restaurants, lowered ticket prices, and made other adjustments In other words, management exercised its option to reformulate the product The park began to make a small profit Then, the company exercised the option to expand by adding a “second gate,” which was another theme park next to Euro Disney named Walt Disney Studios The second gate was intended to encourage visitors to extend their stays But the new park flopped The reasons ranged from high ticket prices, attractions geared toward Hollywood rather than European filmmaking, labor strikes in Paris, and a summer heat wave By the summer of 2003, Euro Disney was close to bankruptcy again Executives discussed a variety of options These options ranged from letting the company go broke (the option to abandon) to pulling the Disney name from the park In 2005, the company finally agreed to a restructuring with the help of the French government After all the changes made at Euro Disney, the park gained momentum for several years, almost breaking even in 2008 In 2014, the resort posted revenues that were percent lower than the previous year and the net loss increased €35 million to €115 million Disney hopes to leverage the lessons learned in its other theme parks around the world For example, in 2014, Hong Kong Disneyland had a total of 7.5 million visitors for the 297 www.downloadslide.net 298 part Capital Budgeting year, resulting in a record revenue of $5.5 billion and a record net income of $332 million And in April 2011, the groundbreaking occurred on a new $4.4 billion theme park in Shanghai that would be opened in the spring of 2016 The whole idea of managerial options was summed up aptly by Jay Rasulo, the overseer of Disney’s theme parks, when he said: “One thing we know for sure is that you never get it 100 percent right the first time We open every one of our parks with the notion that we’re going to add content.” strategic options Options for future, related business products or strategies Strategic Options Companies sometimes undertake new projects just to explore possibilities and evaluate potential future business strategies This is a little like testing the water by sticking a toe in before diving Such projects are difficult to analyze using conventional DCF methods because most of the benefits come in the form of strategic options, that is, options for future, related business moves Projects that create such options may be very valuable, but that value is difficult to measure Research and development, for example, is an important and valuable activity for many firms precisely because it creates options for new products and procedures To give another example, a large manufacturer might decide to open a retail outlet as a pilot study The primary goal is to gain some market insight Because of the high start-up costs, this one operation won’t break even However, based on the sales experience from the pilot, we can then evaluate whether or not to open more outlets, to change the product mix, to enter new markets, and so on The information gained and the resulting options for actions are all valuable, but coming up with a reliable dollar figure is probably not feasible Conclusion We have seen that incorporating options into capital budgeting analysis is not easy What can we about them in practice? The answer is that we can only keep them in the back of our minds as we work with the projected cash flows We will tend to underestimate NPV by ignoring options The damage might be small for a highly structured, very specific proposal, but it might be great for an exploratory one Capital Rationing The situation that exists if a firm has positive net present value projects but cannot obtain the necessary financing Capital rationing is said to exist when we have profitable (positive NPV) investments available but we can’t get the needed funds to undertake them For example, as division managers for a large corporation, we might identify $5 million in excellent projects, but find that, for whatever reason, we can spend only $2 million Now what? Unfortunately, for reasons we will discuss, there may be no truly satisfactory answer soft rationing Soft Rationing The situation we have just described is soft rationing This occurs capital rationing The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting when, for example, different units in a business are allocated some fixed amount of money each year for capital spending Such an allocation is primarily a means of controlling and keeping track of overall spending The important thing about soft rationing is that the corporation as a whole isn’t short of capital; more can be raised on ordinary terms if management so desires If we face soft rationing, the first thing to is try and get a larger allocation Failing that, one common suggestion is to generate as large a net present value as possible within the existing budget This amounts to choosing those projects with the largest benefit-cost ratio (profitability index) Strictly speaking, this is the correct thing to only if the soft rationing is a one-time event; that is, it won’t exist next year If the soft rationing is a chronic problem, then something is amiss The reason goes all the way back to Chapter Ongoing soft rationing www.downloadslide.net chapter 299 Making Capital Investment Decisions means we are constantly bypassing positive NPV investments This contradicts our goal of the firm If we are not trying to maximize value, then the question of which projects to take becomes ambiguous because we no longer have an objective goal in the first place Hard Rationing With hard rationing, a business cannot raise capital for a project un- der any circumstances For large, healthy corporations, this situation probably does not occur very often This is fortunate because with hard rationing, our DCF analysis breaks down, and the best course of action is ambiguous The reason DCF analysis breaks down has to with the required return Suppose we say that our required return is 20 percent Implicitly, we are saying that we will take a project with a return that exceeds this However, if we face hard rationing, then we are not going to take a new project no matter what the return on that project is, so the whole concept of a required return is ambiguous About the only interpretation we can give this situation is that the required return is so large that no project has a positive NPV in the first place Hard rationing can occur when a company experiences financial distress, meaning that bankruptcy is a possibility Also, a firm may not be able to raise capital without violating a preexisting contractual agreement We discuss these situations in greater detail in a later chapter conce p t q u es t i o n s 9.7a 9.7b 9.7c Why we say that our standard discounted cash flow analysis is static? What are managerial options in capital budgeting? Give some examples What is capital rationing? What types are there? What problems does capital rationing create for discounted cash flow analysis? SUMMARY AND CONCLUSIONS This chapter has described how to go about putting together a discounted cash flow analysis and evaluating the results In it, we covered: 1 The identification of relevant project cash flows We discussed project cash flows and described how to handle some issues that often come up, including sunk costs, opportunity costs, financing costs, net working capital, and erosion 2 Preparing and using pro forma, or projected, financial statements We showed how pro forma financial statement information is useful in coming up with projected cash flows 3 The use of scenario and sensitivity analysis These tools are widely used to evaluate the impact of assumptions made about future cash flows and NPV estimates 4 Additional issues in capital budgeting We examined the managerial options implicit in many capital budgeting situations We also discussed the capital rationing problem The discounted cash flow analysis we’ve covered here is a standard tool in the business world It is a very powerful tool, so care should be taken in its use The most important thing is to get the cash flows identified in a way that makes economic sense This chapter gives you a good start on learning to this hard rationing The situation that occurs when a business cannot raise financing for a project under any circumstances www.downloadslide.net 300 part Capital Budgeting POP QUIZ! Can you answer the following questions? If your class is using Connect, log on to SmartBook to see if you know the answers to these and other questions, check out the study tools, and find out what topics require additional practice! Section 9.1 What is the first step in estimating cash flow? Section 9.2 What are sunk costs? Section 9.3 What investment criteria can be applied to estimated cash flows? Section 9.4 If a firm’s current assets are $150,000, its total assets are $320,000, and its current liabilities are $80,000, what is its net working capital? Section 9.5 A project has a positive NPV What could drive this result? Section 9.6 If a firm’s variable cost per unit estimate used in its base case analysis is $50 per unit and it anticipates the upper and lower bounds to be +/− 10 percent, what is the “worst case” for variable cost per unit? Section 9.7 Capital rationing exists when a company has identified positive NPV projects but can’t or won’t find what? CHAPTER REVIEW AND SELF-TEST PROBLEMS Calculating Operating Cash Flow. Mater Pasta, Inc., has projected a sales volume of $1,432 for the second year of a proposed expansion project Costs normally run 70 percent of sales, or about $1,002 in this case The depreciation expense will be $80, and the tax rate is 34 percent What is the operating cash flow? (See Problem 9.) 9.2 Scenario Analysis. A project under consideration costs $500,000, has a five-year life, and has no salvage value Depreciation is straight-line to zero The required return is 15 percent, and the tax rate is 34 percent Sales are projected at 400 units per year Price per unit is $3,000, variable cost per unit is $1,900, and fixed costs are $250,000 per year No net working capital is required Suppose you think the unit sales, price, variable cost, and fixed cost projections are accurate to within percent What are the upper and lower bounds for these projections? What is the base-case NPV? What are the best- and worst-case scenario NPVs? (See Problem 19.) 9.1 ■ Answers to Chapter Review and Self-Test Problems 9.1 First, we can calculate the project’s EBIT, its tax bill, and its net income EBIT = $1,432 − 1,002 − 80 = $350 Taxes = $350 × 34 = $119 Net income = $350 − 119 = $231 With these numbers, operating cash flow is: OCF = EBIT + Depreciation − Taxes = $350 + 80 − 119 = $311 www.downloadslide.net chapter 9.2 We can summarize the relevant information as follows: Base Case Unit sales Price per unit Variable cost per unit Fixed costs 400 $3,000 $1,900 $250,000 Lower Bound Upper Bound 380 $2,850 $1,805 $237,500 420 $3,150 $1,995 $262,500 The depreciation is $100,000 per year, and the tax rate is 34 percent, so we can calculate the cash flows under each scenario Remember that we assign high costs and low prices and volume under the worst case and just the opposite for the best case Scenario Base case Best case Worst case Making Capital Investment Decisions Unit Sales Price Variable Costs Fixed Costs Cash Flow 400 420 380 $3,000 3,150 2,850 $1,900 1,805 1,995 $250,000 237,500 262,500 $159,400 250,084 75,184 At 15 percent, the five-year annuity factor is 3.35216, so the NPVs are: Base-case NPV = −$500,000 + 159,400 × 3.35216 = $34,334 Best-case NPV = −$500,000 + 250,084 × 3.35216 = $338,320 Worst-case NPV = −$500,000 + 75,184 × 3.35216 = −$247,972 CRITICAL THINKING AND CONCEPTS REVIEW LO 9.1 Opportunity Cost. In the context of capital budgeting, what is an opportunity cost? LO 9.2 Depreciation. Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation? Why? 9.3 Net Working Capital. In our capital budgeting examples, we assumed that LO a firm would recover all of the working capital it invested in a project Is this a reasonable assumption? When might it not be valid? LO 9.4 Stand-Alone Principle. Suppose a financial manager is quoted as saying, “Our firm uses the stand-alone principle Because we treat projects like minifirms in our evaluation process, we include financing costs because they are relevant at the firm level.” Critically evaluate this statement 9.5 Cash Flow and Depreciation. “When evaluating projects, we’re only LO concerned with the relevant incremental aftertax cash flows Therefore, because depreciation is a noncash expense, we should ignore its effects when evaluating projects.” Critically evaluate this statement LO 9.6 Capital Budgeting Considerations. A major college textbook publisher has an existing finance textbook The publisher is debating whether or not to produce an “essentialized” version, meaning a shorter (and lower-priced) book What are some of the considerations that should come into play? To answer the next three questions, refer to the following example In 2003, Porsche unveiled its new sports-utility vehicle (SUV), the Cayenne With a price tag of more than $40,000, the Cayenne went from zero to 62 mph in 9.7 seconds Porsche’s decision to enter the SUV market was in response to the runaway success of other high-priced SUVs such as the Mercedes-Benz M-class Vehicles in 301 www.downloadslide.net 302 part Capital Budgeting this class had generated years of very high profits The Cayenne certainly spiced up the market, and Porsche subsequently introduced the Cayenne Turbo S, which goes from zero to 60 mph in 4.8 seconds and has a top speed of 168 mph The price tag for the Cayenne Turbo S? About $114,000 in 2015 Some analysts questioned Porsche’s entry into the luxury SUV market The analysts were concerned not only that Porsche was a late entry into the market, but also that the introduction of the Cayenne would damage Porsche’s reputation as a maker of high-performance automobiles LO 9.7 Erosion. In evaluating the Cayenne, would you consider the possible damage to Porsche’s reputation? 9.8 Capital Budgeting. Porsche was one of the last manufacturers to enter LO the sports-utility vehicle market Why would one company decide to proceed with a product when other companies, at least initially, decide not to enter the market? LO 9.9 Capital Budgeting. In evaluating the Cayenne, what you think Porsche needs to assume regarding the substantial profit margins that exist in this market? Is it likely they will be maintained as the market becomes more competitive, or will Porsche be able to maintain the profit margin because of its image and the performance of the Cayenne? 9.10 Sensitivity Analysis and Scenario Analysis. What is the essential LO difference between sensitivity analysis and scenario analysis? LO 9.11 Marginal Cash Flows. A co-worker claims that looking at all this marginal this and incremental that is just a bunch of nonsense and states: “Listen, if our average revenue doesn’t exceed our average cost, then we will have a negative cash flow, and we will go broke!” How you respond? 9.12 Capital Rationing. Going all the way back to Chapter 1, recall that we LO saw that partnerships and proprietorships can face difficulties when it comes to raising capital In the context of this chapter, the implication is that small businesses will generally face what problem? LO 9.13 Forecasting Risk. What is forecasting risk? In general, would the degree of forecasting risk be greater for a new product or a cost-cutting proposal? Why? 9.14 Options and NPV. What is the option to abandon? The option to expand? LO Explain why we tend to underestimate NPV when we ignore these options QUESTIONS AND PROBLEMS Select problems are available in McGraw-Hill Connect Please see the packaging options section of the preface for more information BASIC (Questions 1–20) LO 1 Relevant Cash Flows. Kenny, Inc., is looking at setting up a new manufacturing plant in South Park The company bought some land six years ago for $5.3 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent facilities elsewhere The land would net $7.4 million if it were sold today The company now wants to build its new manufacturing plant on this land; the plant will cost $26.5 million to build, www.downloadslide.net chapter Making Capital Investment Decisions and the site requires $1.32 million worth of grading before it is suitable for construction What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project? Why? Relevant Cash Flows. Winnebagel Corp currently sells 28,000 motor LO homes per year at $77,000 each and 7,000 luxury motor coaches per year at $120,000 each The company wants to introduce a new portable camper to fill out its product line; it hopes to sell 29,000 of these campers per year at $23,500 each An independent consultant has determined that if the company introduces the new campers, it should boost the sales of its existing motor homes by 2,500 units per year and reduce the sales of its motor coaches by 750 units per year What is the amount to use as the annual sales figure when evaluating this project? Why? LO Calculating Projected Net Income. A proposed new investment has projected sales of $645,000 Variable costs are 40 percent of sales, and fixed costs are $168,000; depreciation is $83,000 Prepare a pro forma income statement assuming a tax rate of 35 percent What is the projected net income? Calculating OCF. Consider the following income statement: LO Sales Costs Depreciation EBIT Taxes (35%) Net income LO LO LO LO $558,400 346,800 94,500 ? ? ? Fill in the missing numbers and then calculate the OCF What is the depreciation tax shield? Calculating Depreciation. A piece of newly purchased industrial equipment costs $715,000 and is classified as seven-year property under MACRS Calculate the annual depreciation allowances and end-of-the-year book values for this equipment Calculating Salvage Value. Consider an asset that costs $545,000 and is depreciated straight-line to zero over its eight-year tax life The asset is to be used in a five-year project; at the end of the project, the asset can be sold for $95,000 If the relevant tax rate is 35 percent, what is the aftertax cash flow from the sale of this asset? Calculating Salvage Value. An asset used in a four-year project falls in the five-year MACRS class for tax purposes The asset has an acquisition cost of $7,100,000 and will be sold for $1,460,000 at the end of the project If the tax rate is 34 percent, what is the aftertax salvage value of the asset? Calculating Project OCF. Rolston Music Company is considering the sale of a new sound board used in recording studios The new board would sell for $27,300, and the company expects to sell 1,500 per year The company currently sells 1,850 units of its existing model per year If the new model is introduced, sales of the existing model will fall to 1,520 units per year The old board retails for $24,900 Variable costs are 55 percent of sales, depreciation on the equipment to produce the new board will be $2,150,000 per year, and fixed costs are $3,200,000 per year If the tax rate is 38 percent, what is the annual OCF for the project? 303 www.downloadslide.net 304 part Capital Budgeting LO Calculating Project OCF. H Cochran, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $1,950,000 The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless The project is estimated to generate $2,145,000 in annual sales, with costs of $1,205,000 If the tax rate is 35 percent, what is the OCF for this project? 10 Calculating Project NPV. In the previous problem, suppose the required LO return on the project is 14 percent What is the project’s NPV? LO 11 Calculating Project Cash Flow from Assets. In the previous problem, suppose the project requires an initial investment in net working capital of $150,000, and the fixed asset will have a market value of $175,000 at the end of the project What is the project’s Year net cash flow? Year 1? Year 2? Year 3? What is the new NPV? 12 NPV and Modified ACRS. In the previous problem, suppose the fixed asset LO actually falls into the three-year MACRS class All the other facts are the same What is the project’s Year net cash flow now? Year 2? Year 3? What is the new NPV? LO 13 Project Evaluation. Kolby’s Korndogs is looking at a new sausage system with an installed cost of $655,000 This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the sausage system can be scrapped for $85,000 The sausage system will save the firm $183,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $35,000 If the tax rate is 34 percent and the discount rate is percent, what is the NPV of this project? 14 Project Evaluation. Your firm is contemplating the purchase of a new LO $410,000 computer-based order entry system The system will be depreciated straight-line to zero over its five-year life It will be worth $30,000 at the end of that time You will save $125,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $35,000 at the beginning of the project Working capital will revert back to normal at the end of the project If the tax rate is 35 percent, what is the IRR for this project? LO 15 Project Evaluation. In the previous problem, suppose your required return on the project is 10 percent and your pretax cost savings are $145,000 per year Will you accept the project? What if the pretax cost savings are only $105,000 per year? 16 Scenario Analysis. Automatic Transmissions, Inc., has the following LO estimates for its new gear assembly project: price = $960 per unit; variable cost = $350 per unit; fixed costs = $3.6 million; quantity = 55,000 units Suppose the company believes all of its estimates are accurate only to within ±15 percent What values should the company use for the four variables given here when it performs its best-case scenario analysis? What about the worst-case scenario? LO 17 Sensitivity Analysis. For the company in the previous problem, suppose management is most concerned about the impact of its price estimate on the project’s profitability How could you address this concern for Automatic Transmissions? Describe how you would calculate your answer What values would you use for the other forecast variables? www.downloadslide.net chapter Making Capital Investment Decisions LO 18 Sensitivity Analysis. We are evaluating a project that costs $1,720,000, has a six-year life, and has no salvage value Assume that depreciation is straight-line to zero over the life of the project Sales are projected at 91,000 units per year Price per unit is $37.95, variable cost per unit is $23.20, and fixed costs are $815,000 per year The tax rate is 35 percent, and we require a return of 11 percent on this project a Calculate the base-case cash flow and NPV What is the sensitivity of NPV to changes in the sales figure? Explain what your answer tells you about a 500-unit decrease in projected sales b What is the sensitivity of OCF to changes in the variable cost figure? Explain what your answer tells you about a $1 decrease in estimated variable costs 19 Scenario Analysis. In the previous problem, suppose the projections given LO for price, quantity, variable costs, and fixed costs are all accurate to within ±10 percent Calculate the best-case and worst-case NPV figures LO 20 Calculating Project Cash Flows and NPV. Pappy’s Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer) Pappy’s paid $120,000 for a marketing survey to determine the viability of the product It is felt that Potato Pet will generate sales of $815,000 per year The fixed costs associated with this will be $196,000 per year, and variable costs will amount to 20 percent of sales The equipment necessary for production of the Potato Pet will cost $865,000 and will be depreciated in a straight-line manner for the years of the product life (as with all fads, it is felt the sales will end quickly) This is the only initial cost for the production Pappy’s has a tax rate of 40 percent and a required return of 13 percent Calculate the payback period, NPV, and IRR INTERMEDIATE (Questions 21–24) LO 21 Cost-Cutting Proposals. CSM Machine Shop is considering a four-year project to improve its production efficiency Buying a new machine press for $375,000 is estimated to result in $142,000 in annual pretax cost savings The press falls in the MACRS five-year class, and it will have a salvage value at the end of the project of $45,000 The press also requires an initial investment in spare parts inventory of $15,000, along with an additional $2,000 in inventory for each succeeding year of the project If the shop’s tax rate is 34 percent and its discount rate is 11 percent, should the company buy and install the machine press? LO 22 Sensitivity Analysis. Consider a three-year project with the following information: initial fixed asset investment = $645,000; straight-line depreciation to zero over the five-year life; zero salvage value; price = $38.70; variable costs = $29.65; fixed costs = $315,000; quantity sold = 90,000 units; tax rate = 34 percent How sensitive is OCF to changes in quantity sold? 23 Project Analysis. You are considering a new product launch The project LO will cost $780,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero Sales are projected at 180 units per year; price per unit will be $16,300, variable cost per unit will be $11,100, and fixed costs will be $535,000 per year The required return on the project is 11 percent, and the relevant tax rate is 35 percent 305 www.downloadslide.net 306 part Capital Budgeting a Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within ±10 percent What are the best and worst cases for these projections? What is the base-case NPV? What are the best-case and worst-case scenarios? b Evaluate the sensitivity of your base-case NPV to changes in fixed costs LO 24 Project Analysis. McGilla Golf has decided to sell a new line of golf clubs The clubs will sell for $825 per set and have a variable cost of $370 per set The company has spent $150,000 for a marketing study that determined the company will sell 74,000 sets per year for seven years The marketing study also determined that the company will lose sales of 8,900 sets per year of its high-priced clubs The high-priced clubs sell at $1,250 and have variable costs of $630 The company will also increase sales of its cheap clubs by 11,000 sets per year The cheap clubs sell for $375 and have variable costs of $140 per set The fixed costs each year will be $14,350,000 The company has also spent $1,000,000 on research and development for the new clubs The plant and equipment required will cost $29,400,000 and will be depreciated on a straight-line basis The new clubs will also require an increase in net working capital of $3,500,000 that will be returned at the end of the project The tax rate is 40 percent, and the cost of capital is 14 percent Calculate the payback period, the NPV, and the IRR CHALLENGE (Questions 25–26) LO 25 Project Evaluation. Aria Acoustics, Inc (AAI), projects unit sales for a new seven-octave voice emulation implant as follows: Year Unit Sales 67,500 83,900 98,700 86,000 72,000 Production of the implants will require $1,500,000 in net working capital to start and additional net working capital investments each year equal to 15 percent of the projected sales increase for the following year Total fixed costs are $1,950,000 per year, variable production costs are $230 per unit, and the units are priced at $355 each The equipment needed to begin production has an installed cost of $18,500,000 Because the implants are intended for professional singers, this equipment is considered industrial machinery and thus qualifies as seven-year MACRS property In five years, this equipment can be sold for about 20 percent of its acquisition cost AAI is in the 35 percent marginal tax bracket and has a required return on all its projects of 15 percent Based on these preliminary project estimates, what is the NPV of the project? What is the IRR? 26 Calculating Required Savings. A proposed cost-saving device has an LO installed cost of $535,000 The device will be used in a five-year project but is classified as three-year MACRS property for tax purposes The required initial net working capital investment is $38,000, the marginal tax rate is 35 percent, and the project discount rate is 12 percent The device has an estimated Year salvage value of $50,000 What level of pretax cost savings we require for this project to be profitable? www.downloadslide.net chapter Making Capital Investment Decisions EXCEL MASTER IT! PROBLEM For this Master It! assignment, refer to the Conch Republic Electronics case at the end of Chapter For your convenience, we have entered the relevant values in the case, such as the price and variable cost, already For this project, answer the following questions a What is the profitability index of the project? b What is the IRR of the project? c What is the NPV of the project? d How sensitive is the NPV to changes in the price of the new smartphone? Construct a one-way data table to help you e How sensitive is the NPV to changes in the quantity sold? 307 www.downloadslide.net 308 part Capital Budgeting CHAPTER CASE Conch Republic Electronics C onch Republic Electronics is a midsized electronics manufacturer located in Key West, Florida The company president is Shelly Couts, who inherited the company The company originally repaired radios and other household appliances when it was founded more than 70 years ago Over the years, the company has expanded, and it is now a reputable manufacturer of various specialty electronic items Jay McCanless, a recent MBA graduate, has been hired by the company in its finance department One of the major revenue-producing items manufactured by Conch Republic is a smartphone Conch Republic currently has one smartphone model on the market and sales have been excellent The smartphone is a unique item in that it comes in a variety of tropical colors and is preprogrammed to play Jimmy Buffett music However, as with any electronic item, technology changes rapidly, and the current smartphone has limited features in comparison with newer models Conch Republic spent $750,000 to develop a prototype for a new smartphone that has all the features of the existing one but adds new features such as wifi tethering The company has spent a further $200,000 for a marketing study to determine the expected sales figures for the new smartphone Conch Republic can manufacture the new smartphone for $205 each in variable costs Fixed costs for the operation are estimated to run $5.1 million per year The estimated sales volume is 64,000, 106,000, 87,000, 78,000, and 54,000 per year for the next five years, respectively The unit price of the new smartphone will be $485 The necessary equipment can be purchased for $34.5 million and will be depreciated on a seven-year MACRS schedule It is believed the value of the equipment in five years will be $5.5 million Net working capital for the smartphones will be 20 percent of sales and will occur with the timing of the cash flows for the year (i.e., there is no initial outlay for NWC) Changes in NWC will thus first occur in Year with the first year’s sales Conch Republic has a 35 percent corporate tax rate and a required return of 12 percent Shelly has asked Jay to prepare a report that answers the following questions: QUESTIONS What is the payback period of the project? What is the profitability index of the project? What is the IRR of the project? What is the NPV of the project? How sensitive is the NPV to changes in the price of the new smartphone? How sensitive is the NPV to changes in the quantity sold? S hould Conch Republic produce the new smartphone? Suppose Conch Republic loses sales on other models because of the introduction of the new model How would this affect your analysis? ... close to 10 percent A little trial and error reveals that the yield is actually 11 percent: www.downloadslide.net Bond value = $10 0 × (1 − 1/ 1 .11 12)/ .11 + 1, 000 /1. 111 2 = $10 0 × 6.4924 + 1, 000/3.4985... at a premium because of its $12 0 coupon Its With an 11 percent theWEB? second bond value is: These end -of- chapter activities show stu $12 0 × (1 − 1/ 1 .11 )/ .11 +from 1, 000 /1. 11the vast dents Bond... 9 .1 SELF-TEST PROBLEMS Pasta, Inc., has projected a sales volume Calculating Operating Cash Flow Materros77 216 _ch09_274-308.indd 299 1/ 1 .11 6 = 1/ 1.8704 =for 5346 of $1, 432 the second year of