Question

DCF analysis doesn't always lead to proper capital budgeting decisions because capital budgeting projects are not-Select-investments like stocks and bonds. Managers can often take positive actions after the investment has been made to alter a project's cash flows. These opportunities are real options that offer the right but not the obligation to take some future action. Types of real options include abandonment, investment timing, expansion, output flexibility, and input flexibility. The existence of options can -Select projects' expected profitability,-Select their calculated NPVS, and -Select their risk. The abandonment option is the option to shut down a project if operating cash flows turn out to be lower than expected. To analyze the abandonment option you can draw a decision tree, which is a diagram that lays out different branches that are the result of different decisions made or the result of different economic situations. When analyzing real options you consider the project with and without the option. The option value is calculated as the difference between the expected NPVS with and without the relevant option. (If the value of the project without the option is negative and the NPV of the project with the option is positive, then the option value is simply the calculated NPV of the option.) It is the value that is not accounted for in a traditional NPV analysis and a positive option value expands the firm's opportunities Quantitative Problem: Sunshine Smoothies Company (SSC) manufactures and distributes smoothies. SsC is considering the development of a new line of high-protein energy smoothies. SSC's CFO has collected the following information regarding the proposed project, which is expected to last 3 years The project can be operated at the company's Charleston plant, which is currently vacant. The project will require that the company spend $4.5 million today (t 0) to purchase additional equipment. This equipment is eligible for 100 % bonus depreciation, so the equipment is fully depreciated at the time of its purchase. The company plans to use the equipment for all 3 years of the project. At t 3 (which is the project's last year of operation), the equipment is expected to be sold for $1,800,000 before taxes The project will require an increase in net operating working capital of $730,000 at t 0. The cost of the working capital will be fully recovered at t = 3 (which is the project's last year of operation). Expected high-protein energy smoothie sales are as follows: Year Sales 1 $2,100,000 2 8,000,000 3,150,000 3 The project's annual operating costs (excluding depreciation) are expected to be 60% of sales The company's tax rate is 25% The company is extremely profitable; so if any losses are incurred from the high-protein energy smoothie project they can be used to partially offset taxes paid on the company's other projects. (That is, assume that if there are any tax credits related to this project they can be used in the year they occur.) 10.0 % . The project has a WACC What is the project's expected NPV and IRR? Round your answers to 2 decimal places. Do not round your intermediate calculations NPV IRR Should the firm accept the project? -Select SSC is considering another project: the introduction of a "weight loss smoothie. The project would require a $3.2 million investment outlay today (t0). The after-tax cash flows would depend on whether the "weight loss smoothie is well received by consumers. There is a 40% chance that demand will be good, in which case the project will produce after-tax cash flows of $2.3 million at the end of each of the next 3 years. There is a 60% chance that demand will be poor, in which case the after-tax cash flows will be $0.49 million for 3 years. The project is riskier than the firm's other projects, so it has a WACC of 11%. The firm will know if the project is successful after receiving the cash flows the first year, and after receiving the first year's cash flows it will have the option to abandon the project. If the firm decides to abandon the project the company will not receive any cash flows after t 1, but it will be able to sell the assets related to the project for $2.5 million after taxes at t 1. Assuming the company has an option to abandon the project, what is the expected NPV of the project today? Round your answer to 2 decimal places. Do not round your intermediate caIculations. Use the values in "millions of dollars" to ascertain the answer millions of dollars

Answer 1

Ans 1)

Calculation of net discounted cash inflows

	Year 1 (Amount in millions)	Year 2 (Amount in millions)	Year 3(Amount in millions)
Sales	2100000	8000000	3150000
Less Operating Expenses	1260000	4800000	1890000
Less Depreciation	900000	900000	900000
	-60000	2300000	360000
Less Tax @25%	-15000	575000	90000
	-75000	1725000	270000
add tax on depreciation depreciation	900000	900000	900000
add working capital release			730000
cash inflows	825000	2625000	1900000
discounting factor @10 %	0.909	0.826	0.751
PV at10%	749925	2168250	1426900
discounting Factor at @15%	0.869	0.743	0.641
	716925	1984500	1248300
discounting Factor at @17%	0.855	0.731	0.624
	705375	1918875	1185600

Calculation of NPV

=net cash inflows -Initial Investment

=749925+2168250+1426900-4500000-730000+1351800=466875

IRR=15+(3949825-3878200/3949825-3809850)*2

=15+(71625/139975)*2

=15+1.02=16.02%

Ans 2)

Calculation of cash inflows

If demand will be good	(Amount in millions)
After-tax cash inflow	2300000
sell value of the asset after 1 year	2500000
Total	4800000
Pv at 11%	0.901
	4324324
Less Initial Investment	3200000
NPV	1124324

If demand will not be goo	(Amount in millions)
After-tax cash inflow	490000
sell value of the asset after 1 year	2500000
Total	2990000
Pv at 11%	0.901
	2693990
Less Initial Investment	3200000
NPV	-506010

There is more chances that the project will not be good and NPV of it is negative therefore the project should be rejected