Fundamentals of Corporate Finance

10th Edition Ross Solutions Manual

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Chapter 11 - Project Analysis and Evaluation

CHAPTER 11
PROJECT ANALYSIS AND EVALUATION
Answers to Concepts Review and Critical Thinking Questions

1. Forecasting risk is the risk that a poor decision is made because of errors in projected cash flows.
The danger is greatest with a new product because the cash flows are probably harder to predict.

2. With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario
analysis, all variables are examined for a limited range of values.

3. It is true that if average revenue is less than average cost, the firm is losing money. This much of the
statement is therefore correct. At the margin, however, accepting a project with marginal revenue in
excess of its marginal cost clearly acts to increase operating cash flow.

4. It makes wages and salaries a fixed cost, driving up operating leverage.

5. Fixed costs are relatively high because airlines are relatively capital intensive (and airplanes are
expensive). Skilled employees such as pilots and mechanics mean relatively high wages which,
because of union agreements, are relatively fixed. Maintenance expenses are significant and
relatively fixed as well.

6. From the shareholder perspective, the financial breakeven point is the most important. A project can
exceed the accounting and cash breakeven points but still be below the financial breakeven point.
This causes a reduction in shareholder (your) wealth.

7. The project will reach the cash break-even first, the accounting break-even next and finally the
financial breakeven. For a project with an initial investment and sales after, this ordering will always
apply. The cash break-even is achieved first since it excludes depreciation. The accounting break-
even is next since it includes depreciation. Finally, the financial break-even, which includes the time
value of money, is achieved.

8. Soft capital rationing implies that the firm as a whole isn’t short of capital, but the division or project
does not have the necessary capital. The implication is that the firm is passing up positive NPV
projects. With hard capital rationing the firm is unable to raise capital for a project under any
circumstances. Probably the most common reason for hard capital rationing is financial distress,
meaning bankruptcy is a possibility.

9. The implication is that they will face hard capital rationing.

10. While that fact that the worst-case NPV is positive is interesting, it also indicates that there is likely a
problem with the inputs and/or analysis. While we would like all of our projects to be guaranteed to
make money, as a practical matter, it doesn’t seem likely that these types of projects are very
prevalent.

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Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.

Basic

1. a. The total variable cost per unit is the sum of the two variable costs, so:

Total variable costs per unit = $10.48 + 6.89

Total variable costs per unit = $17.37

b. The total costs include all variable costs and fixed costs. We need to make sure we are
including all variable costs for the number of units produced, so:

Total costs = Variable costs + Fixed costs

Total costs = $17.37(280,000) + $870,000
Total costs = $5,733,600

c. The cash breakeven, that is the point where cash flow is zero, is:

QC = $870,000 / ($49.99 – 17.37)

QC = 26,670.75 units

And the accounting breakeven is:

QA = ($870,000 + 490,000) / ($49.99 – 17.37)

QA = 41,692.21 units

2. The total costs include all variable costs and fixed costs. We need to make sure we are including all
variable costs for the number of units produced, so:

Total costs = ($31.85 + 22.80)(120,000) + $1,750,000

Total costs = $8,308,000

The marginal cost, or cost of producing one more unit, is the total variable cost per unit, so:

Marginal cost = $31.85 + 22.80

Marginal cost = $54.65

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The average cost per unit is the total cost of production, divided by the quantity produced, so:

Average cost = Total cost / Total quantity

Average cost = $8,308,000/120,000
Average cost = $69.23

Minimum acceptable total revenue = 5,000($54.65)

Minimum acceptable total revenue = $273,250

Additional units should be produced only if the cost of producing those units can be recovered.

3. The base-case, best-case, and worst-case values are shown below. Remember that in the best-case,
sales and price increase, while costs decrease. In the worst-case, sales and price decrease, and costs
increase.
Unit
Scenario Unit Sales Unit Price Variable Cost Fixed Costs
Base 85,000 $1,400 $220 $3,900,000
Best 97,750 1,610 187 3,315,000
Worst 72,250 1,190 253 4,485,000

4. An estimate for the impact of changes in price on the profitability of the project can be found from
the sensitivity of NPV with respect to price: NPV/P. This measure can be calculated by finding
the NPV at any two different price levels and forming the ratio of the changes in these parameters.
Whenever a sensitivity analysis is performed, all other variables are held constant at their base-case
values.

5. a. To calculate the accounting breakeven, we first need to find the depreciation for each year. The
depreciation is:

Depreciation = $924,000/8
Depreciation = $115,500 per year

And the accounting breakeven is:

QA = ($825,000 + 115,500)/($46 – 31)

QA = 62,700 units

To calculate the accounting breakeven, we must realize at this point (and only this point), the
OCF is equal to depreciation. So, the DOL at the accounting breakeven is:

DOL = 1 + FC/OCF = 1 + FC/D

DOL = 1 + [$825,000/$115,500]
DOL = 8.143

b. We will use the tax shield approach to calculate the OCF. The OCF is:

OCFbase = [(P – v)Q – FC](1 – T) + TD

OCFbase = [($46 – 31)(90,000) – $825,000](0.65) + 0.35($115,500)
OCFbase = $235,425

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Now we can calculate the NPV using our base-case projections. There is no salvage value or
NWC, so the NPV is:

NPVbase = –$924,000 + $235,425(PVIFA15%,8)

NPVbase = $132,427.67

To calculate the sensitivity of the NPV to changes in the quantity sold, we will calculate the
NPV at a different quantity. We will use sales of 80,000 units. The NPV at this sales level is:

OCFnew = [($46 – 31)(80,000) – $825,000](0.65) + 0.35($115,500)

OCFnew = $284,175

And the NPV is:

NPVnew = –$924,000 + $284,175(PVIFA15%,8)

NPVnew = $351,184.59

So, the change in NPV for every unit change in sales is:

NPV/S = ($132,427.67 – 351,184.59)/(75,000 – 80,000)

NPV/S = +$43.751

If sales were to drop by 500 units, then NPV would drop by:

NPV drop = $43.751(500) = $21,875.69

You may wonder why we chose 95,000 units. Because it doesn’t matter! Whatever sales
number we use, when we calculate the change in NPV per unit sold, the ratio will be the same.

c. To find out how sensitive OCF is to a change in variable costs, we will compute the OCF at a
variable cost of $32. Again, the number we choose to use here is irrelevant: We will get the
same ratio of OCF to a one dollar change in variable cost no matter what variable cost we use.
So, using the tax shield approach, the OCF at a variable cost of $32 is:

OCFnew = [($46 – 32)(90,000) – 825,000](0.65) + 0.35($115,500)

OCFnew = $186,675

So, the change in OCF for a $1 change in variable costs is:

OCF/v = ($284,175 – 186,675)/($31 – 32)

OCF/v = –$48,750

If variable costs decrease by $1 then, OCF would increase by $48,750

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6. We will use the tax shield approach to calculate the OCF for the best- and worst-case scenarios. For
the best-case scenario, the price and quantity increase by 10 percent, so we will multiply the base
case numbers by 1.1, a 10 percent increase. The variable and fixed costs both decrease by 10 percent,
so we will multiply the base case numbers by .9, a 10 percent decrease. Doing so, we get:

OCFbest = {[($46)(1.1) – ($31)(0.9)](90,000)(1.1) – $825,000(0.9)}(0.65) + 0.35($115,500)

OCFbest = $775,087.50

The best-case NPV is:

NPVbest = –$924,000 + $775,087.50(PVIFA15%,8)

NPVbest = $2,554,066.81

For the worst-case scenario, the price and quantity decrease by 10 percent, so we will multiply the
base case numbers by .9, a 10 percent decrease. The variable and fixed costs both increase by 10
percent, so we will multiply the base case numbers by 1.1, a 10 percent increase. Doing so, we get:

OCFworst = {[($46)(0.9) – ($31)(1.1)](90,000)(0.9) – $825,000(1.1)}(0.65) + 0.35($115,500)

OCFworst = –$229,162.50

The worst-case NPV is:

NPVworst = –$924,000 – $229,162.50(PVIFA15%,8)

NPVworst = –$1,952,325.82

7. The cash breakeven equation is:

QC = FC/(P – v)

And the accounting breakeven equation is:

QA = (FC + D)/(P – v)

Using these equations, we find the following cash and accounting breakeven points:

a. QC = $9,000,000/($3,020 – 2,275) QA = ($9,000,000 + 3,100,000)/($3,020 – 2,275)

QC = 12,080.54 QA = 16,241.61

b. QC = $73,000/($46 – 41) QA = ($73,000 + 150,000)/($46 – 41)

QC = 14,600 QA = 44,600

c. QC = $1,700/($11 – 4) QA = ($1,700 + 930)/($11 – 4)

QC = 242.86 QA = 375.71

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8. We can use the accounting breakeven equation:

QA = (FC + D)/(P – v)

to solve for the unknown variable in each case. Doing so, we find:

(1): QA = 112,800 = ($820,000 + D)/($39 – 30)

D = $195,200

(2): QA = 165,000 = ($3,200,000 + 1,150,000)/(P – $27)

P = $53.36

(3): QA = 4,385 = ($160,000 + 105,000)/($92 – v)

v = $31.57

9. The accounting breakeven for the project is:

QA = [$15,500 + ($24,000/4)]/($62 – 41)

QA = 1,023.81

And the cash breakeven is:

QC = $15,500/($62 – 41)
QC = 738.10

At the financial breakeven, the project will have a zero NPV. Since this is true, the initial cost of the
project must be equal to the PV of the cash flows of the project. Using this relationship, we can find
the OCF of the project must be:

NPV = 0 implies $24,000 = OCF(PVIFA12%,4)

OCF = $7,901.63

Using this OCF, we can find the financial breakeven is:

QF = ($15,500 + $7,901.63)/($62 – 41) = 1,114.36

And the DOL of the project is:

DOL = 1 + ($15,500/$7,901.63) = 2.962

10. In order to calculate the financial breakeven, we need the OCF of the project. We can use the cash
and accounting breakeven points to find this. First, we will use the cash breakeven to find the price
of the product as follows:

QC = FC/(P – v)
10,600 = $150,000/(P – $24)
P = $38.15

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Now that we know the product price, we can use the accounting breakeven equation to find the
depreciation. Doing so, we find the annual depreciation must be:

QA = (FC + D)/(P – v)
13,400 = ($150,000 + D)/($38.15 – 24)
Depreciation = $39,623

We now know the annual depreciation amount. Assuming straight-line depreciation is used, the
initial investment in equipment must be five times the annual depreciation, or:

Initial investment = 5($39,623) = $198,113

The PV of the OCF must be equal to this value at the financial breakeven since the NPV is zero, so:

$197,113 = OCF(PVIFA16%,5)
OCF = $54,958.53

We can now use this OCF in the financial breakeven equation to find the financial breakeven sales
quantity is:

QF = ($150,000 + 54,958.53)/($38.15 – 24)

QF = 14,483.74

11. We know that the DOL is the percentage change in OCF divided by the percentage change in
quantity sold. Since we have the original and new quantity sold, we can use the DOL equation to
find the percentage change in OCF. Doing so, we find:

DOL = %OCF / %Q

Solving for the percentage change in OCF, we get:

%OCF = (DOL)(%Q)
%OCF = 2.90[(78,000 – 73,000)/73,000]
%OCF = .1986, or 19.86%

The new level of operating leverage is lower since FC/OCF is smaller.

12. Using the DOL equation, we find:

DOL = 1 + FC / OCF
2.90 = 1 + $150,000/OCF
OCF = $78,947

The percentage change in quantity sold at 67,000 units is:

%ΔQ = (67,000 – 73,000) / 73,000

%ΔQ = –.0822, or –8.22%

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So, using the same equation as in the previous problem, we find:

%ΔOCF = 2.90(–8.22%)
%ΔQ = –23.84%

So, the new OCF level will be:

New OCF = (1 – .2384)($78,947)

New OCF = $60,130

And the new DOL will be:

New DOL = 1 + ($150,000/$60,130)

New DOL = 3.495

13. The DOL of the project is:

DOL = 1 + ($84,000/$93,200)
DOL = 1.9013

If the quantity sold changes to 8,000 units, the percentage change in quantity sold is:

%Q = (8,000 – 7,500)/7,500

%ΔQ = .0667, or 6.67%

So, the OCF at 8,000 units sold is:

%OCF = DOL(%Q)
%ΔOCF = 1.9013(.0667)
%ΔOCF = .1268, or 12.68%

This makes the new OCF:

New OCF = $93,200(1.1268)

New OCF = $105,013.33

And the DOL at 8,000 units is:

DOL = 1 + ($84,000/$105,013.33)
DOL = 1.7999

14. We can use the equation for DOL to calculate fixed costs. The fixed cost must be:

DOL = 2.61 = 1 + FC/OCF

FC = (2.61 – 1)$57,000
FC = $91,770

If the output rises to 16,000 units, the percentage change in quantity sold is:

%Q = (16,000 – 15,000)/15,000

%ΔQ = .0667, or 6.67%

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The percentage change in OCF is:

%OCF = 2.61(.0667)
%ΔOCF = .1740, or 17.40%

So, the operating cash flow at this level of sales will be:

OCF = $57,000(1.1740)
OCF = $66,918

If the output falls to 14,000 units, the percentage change in quantity sold is:

%Q = (14,000 – 15,000)/15,000

%ΔQ = –.0667, or –6.67%

The percentage change in OCF is:

%OCF = 2.61(–.0667)
%ΔOCF = –.1740, or –17.40%

So, the operating cash flow at this level of sales will be:

OCF = $57,000(1 – .1740)

OCF = $47,082

15. Using the equation for DOL, we get:

DOL = 1 + FC/OCF

At 16,000 units
DOL = 1 + $91,770/$66,918
DOL = 2.3714

At 14,000 units
DOL = 1 + $91,770/$47,082
DOL = 2.9492

Intermediate

16. a. At the accounting breakeven, the IRR is zero percent since the project recovers the initial
investment. The payback period is N years, the length of the project since the initial investment
is exactly recovered over the project life. The NPV at the accounting breakeven is:

NPV = I [(1/N)(PVIFAR%,N) – 1]

b. At the cash breakeven level, the IRR is –100 percent, the payback period is negative, and the
NPV is negative and equal to the initial cash outlay.

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c. The definition of the financial breakeven is where the NPV of the project is zero. If this is true,
then the IRR of the project is equal to the required return. Assuming that the required return is
positive, it is impossible to state the payback period, except to say that the payback period must
be less or equal to the length of the project. Since the discounted cash flows are equal to the
initial investment, the undiscounted cash flows must be greater than or equal to the initial
investment, so the payback must be less or equal to the project life.

17. Using the tax shield approach, the OCF at 110,000 units will be:

OCF = [(P – v)Q – FC](1 – T) + T(D)

OCF = [($25 – 16)(75,000) – 180,000](0.66) + 0.34($420,000/4)
OCF = $362,400

We will calculate the OCF at 76,000 units. The choice of the second level of quantity sold is
arbitrary and irrelevant. No matter what level of units sold we choose, we will still get the same
sensitivity. So, the OCF at this level of sales is:

OCF = [($25 – 16)(76,000) – 180,000](0.66) + 0.34($420,000/4)

OCF = $368,340

The sensitivity of the OCF to changes in the quantity sold is:

Sensitivity = OCF/Q = ($362,400 – 368,340)/(75,000 – 76,000)

OCF/Q = +$5.94

OCF will increase by $5.94 for every additional unit sold.

18. At 75,000 units, the DOL is:

DOL = 1 + FC/OCF
DOL = 1 + ($180,000/$362,400)
DOL = 1.4967

The accounting breakeven is:

QA = (FC + D)/(P – v)
QA = [$180,000 + ($420,000/4)]/($25 – 16)
QA = 31,667

And, at the accounting breakeven level, the DOL is:

DOL = 1 + [$180,000/($420,000/4)]
DOL = 2.7143

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19. a. The base-case, best-case, and worst-case values are shown below. Remember that in the best-
case, sales and price increase, while costs decrease. In the worst-case, sales and price decrease,
and costs increase.

Scenario Unit Sales Variable Cost Fixed Costs

Base 180 $9,800 $430,000
Best 198 8,820 387,000
Worst 162 10,780 473,000

Using the tax shield approach, the OCF and NPV for the base case estimate is:

OCFbase = [($16,000 – 9,800)(180) – $430,000](0.65) + 0.35($1,400,000/4)

OCFbase = $568,400

NPVbase = –$1,400,000 + $568,400(PVIFA12%,4)

NPVbase = $326,429.37

The OCF and NPV for the worst case estimate are:

OCFworst = [($16,000 – 10,780)(162) – $473,000](0.65) + 0.35($1,400,000/4)

OCFworst = $364,716

NPVworst = –$1,400,000 + $364,716(PVIFA12%,4)

NPVworst = –$292,230.10

And the OCF and NPV for the best case estimate are:

OCFbest = [($16,000 – 8,820)(198) – $387,000](0.65) + 0.35($1,400,000/4)

OCFbest = $795,016

NPVbest = –$1,400,000 + $795,016(PVIFA12%,4)

NPVbest = $1,014,741.33

b. To calculate the sensitivity of the NPV to changes in fixed costs we choose another level of
fixed costs. We will use fixed costs of $440,000. The OCF using this level of fixed costs and
the other base case values with the tax shield approach, we get:

OCF = [($16,000 – 9,800)(180) – $430,000](0.65) + 0.35($1,400,000/4)

OCF = $561,900

And the NPV is:

NPV = –$1,400,000 + $561,900(PVIFA12%,4)

NPV = $306,686.60

The sensitivity of NPV to changes in fixed costs is:

NPV/FC = ($326,429.37 – 306,686.60)/($430,000 – 440,000)

NPV/FC = –$1.974

For every dollar FC increase, NPV falls by $1.974.

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c. The cash breakeven is:

QC = FC/(P – v)
QC = $430,000/($16,000 – 9,800)
QC = 69.35

d. The accounting breakeven is:

QA = (FC + D)/(P – v)
QA = [$430,000 + ($1,400,000/4)]/($16,000 – 9,800)
QA = 125.81

At the accounting breakeven, the DOL is:

DOL = 1 + FC/OCF
DOL = 1 + ($440,000/$350,000) = 2.229

For each 1% increase in unit sales, OCF will increase by 2.229%.

20. The marketing study and the research and development are both sunk costs and should be ignored.
We will calculate the sales and variable costs first. Since we will lose sales of the expensive clubs
and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales for the new
project will be:

Sales
New clubs $825  55,000 = $45,375,000
Exp. clubs $1,100  (–10,000) = –11,000,000
Cheap clubs $410  12,000 = 4,920,000
$39,925,000

For the variable costs, we must include the units gained or lost from the existing clubs. Note that the
variable costs of the expensive clubs are an inflow. If we are not producing the sets anymore, we will
save these variable costs, which is an inflow. So:

Var. Costs
New clubs –$395  55,000 = –$21,725,000
Exp. clubs –$650  (–10,000) = 6,500,000
Cheap clubs –$185  12,000 = –2,220,000
–$17,445,000

The pro forma income statement will be:

Sales $39,925,000
Variable costs 17,445,000
Costs 9,200,000
Depreciation 4,200,000
EBT $8,450,000
Taxes 3,380,000
Net income $5,070,000

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Using the bottom up OCF calculation, we get:

OCF = NI + Depreciation = $5,070,000 + 4,200,000

OCF = $9,270,000

So, the payback period is:

Payback period = 3 + $2,990,000/$9,270,000

Payback period = 3.323 years

The NPV is:

NPV = –$29,400,000 – 1,400,000 + $9,270,000(PVIFA10%,7) + $1,400,000/1.107

NPV = $15,048,663.81

And the IRR is:

IRR = –$29,400,000 – 1,400,000 + $9,270,000(PVIFAIRR%,7) + $1,400,000/IRR7

IRR = 23.46%

21. The best case and worst cases for the variables are:

Base Case Best Case Worst Case

Unit sales (new) 55,000 60,500 49,500
Price (new) $825 $908 $743
VC (new) $395 $356 $435
Fixed costs $9,200,000 $8,280,000 $10,120,000
Sales lost (expensive) 10,000 9,000 11,000
Sales gained (cheap) 12,000 13,200 10,800

Best-case
We will calculate the sales and variable costs first. Since we will lose sales of the expensive clubs
and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales for the new
project will be:

Sales
New clubs $908  60,500 = $54,903,750
Exp. clubs $1,100  (–9,000) = – 9,900,000
Cheap clubs $410  13,200 = 5,412,000
$50,415,750

For the variable costs, we must include the units gained or lost from the existing clubs. Note that the
variable costs of the expensive clubs are an inflow. If we are not producing the sets anymore, we will
save these variable costs, which is an inflow. So:

Var. Costs
New clubs –$356  60,500 = –$21,507,750
Exp. clubs –$650  (–9,000) = 5,850,000
Cheap clubs –$185  13,200 = – 2,442,000
–$18,099,750

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The pro forma income statement will be:

Sales $50,415,750
Variable costs 18,099,750
Costs 8,280,000
Depreciation 4,200,000
EBT 19,836,000
Taxes 7,934,400
Net income $11,901,600

Using the bottom up OCF calculation, we get:

OCF = Net income + Depreciation = $11,901,600 + 4,200,000

OCF = $16,101,600

And the best-case NPV is:

NPV = –$29,400,000 – 1,400,000 + $16,101,600(PVIFA10%,7) + 1,400,000/1.107

NPV = $48,307,753.80

Worst Case
We will calculate the sales and variable costs first. Since we will lose sales of the expensive clubs
and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales for the new
project will be:

Sales
New clubs $743  49,500 = $36,753,750
Exp. clubs $1,100  (– 11,000) = – 12,100,000
Cheap clubs $410  10,800 = 4,428,000
$29,081,750

For the variable costs, we must include the units gained or lost from the existing clubs. Note that the
variable costs of the expensive clubs are an inflow. If we are not producing the sets anymore, we will
save these variable costs, which is an inflow. So:

Var. Costs
New clubs –$743  49,500 = –$21,507,750
Exp. clubs –$650  (– 11,000) = 7,150,000
Cheap clubs –$185  10,800 = – 1,998,000
–$16,355,750

The pro forma income statement will be:

Sales $29,081,750
Variable costs 16,355,750
Costs 10,120,000
Depreciation 4,200,000
EBT – 1,594,700
Taxes 637,600 *assumes a tax credit

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Net income –$956,400

Using the bottom up OCF calculation, we get:

OCF = NI + Depreciation = –$956,400 + 4,200,000

OCF = $3,243,600

And the worst-case NPV is:

NPV = –$29,400,000 – 1,400,000 + $3,243,600(PVIFA10%,7) + 1,400,000/1.107

NPV = –$14,290,375.36

22. To calculate the sensitivity of the NPV to changes in the price of the new club, we simply need to
change the price of the new club. We will choose $850, but the choice is irrelevant as the sensitivity
will be the same no matter what price we choose.

We will calculate the sales and variable costs first. Since we will lose sales of the expensive clubs
and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales for the new
project will be:

Sales
New clubs $850  55,000 = $46,750,000
Exp. clubs $1,100  (–10,000) = –11,000,000
Cheap clubs $410  12,000 = 4,920,000
$40,670,000

For the variable costs, we must include the units gained or lost from the existing clubs. Note that the
variable costs of the expensive clubs are an inflow. If we are not producing the sets anymore, we will
save these variable costs, which is an inflow. So:

Var. costs
New clubs –$395  55,000 = –$21,725,000
Exp. clubs –$650  (–10,000) = 6,500,000
Cheap clubs –$185  12,000 = –2,220,000
–$17,445,000

The pro forma income statement will be:

Sales $40,670,000
Variable costs 17,445,000
Costs 9,200,000
Depreciation 4,200,000
EBT 9,825,000
Taxes 3,930,000
Net income $ 5,895,000

Using the bottom up OCF calculation, we get:

OCF = NI + Depreciation = $5,895,000 + 4,200,000

OCF = $10,095,000

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And the NPV is:

NPV = –$29,400,000 – 1,400,000 + $10,095,000(PVIFA10%,7) + 1,400,000/1.107

NPV = $19,065,109.33

So, the sensitivity of the NPV to changes in the price of the new club is:

NPV/P = ($15,048,663.81 – 19,065,109.33)/($825 – 850)

NPV/P = $160,657.82

For every dollar increase (decrease) in the price of the clubs, the NPV increases (decreases) by
$160,657.82.

To calculate the sensitivity of the NPV to changes in the quantity sold of the new club, we simply
need to change the quantity sold. We will choose 56,000 units, but the choice is irrelevant as the
sensitivity will be the same no matter what quantity we choose.

We will calculate the sales and variable costs first. Since we will lose sales of the expensive clubs
and gain sales of the cheap clubs, these must be accounted for as erosion. The total sales for the new
project will be:

Sales
New clubs $825  56,000 = $46,200,000
Exp. clubs $1,100  (–10,000) = –11,000,000
Cheap clubs $410  12,000 = 4,920,000
$40,120,000

For the variable costs, we must include the units gained or lost from the existing clubs. Note that the
variable costs of the expensive clubs are an inflow. If we are not producing the sets anymore, we will
save these variable costs, which is an inflow. So:

Var. costs
New clubs –$395  56,000 = –$22,120,000
Exp. clubs –$650  (–10,000) = 6,500,000
Cheap clubs –$185  12,000 = –2,220,000
–$17,840,000

The pro forma income statement will be:

Sales $40,120,000
Variable costs 17,840,000
Costs 9,200,000
Depreciation 4,200,000
EBT 8,880,000
Taxes 3,552,000
Net income $ 5,328,000

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Using the bottom up OCF calculation, we get:

OCF = NI + Depreciation = $5,328,000 + 4,200,000

OCF = $9,528,000

The NPV at this quantity is:

NPV = –$29,400,000 – $1,400,000 + $9,528,000(PVIFA10%,7) + $1,400,000/1.107

NPV = $16,304,715.86

So, the sensitivity of the NPV to changes in the quantity sold is:

NPV/Q = ($15,048,663.81 – 16,304,715.86)/(55,000 – 56,000)

NPV/Q = $1,256.05

For an increase (decrease) of one set of clubs sold per year, the NPV increases (decreases) by
$1,256.05.

23. a. First we need to determine the total additional cost of the hybrid. The hybrid costs more to
purchase and more each year, so the total additional cost is:

Total additional cost = $5,565 + 6($300)

Total additional cost = $7,365

Next, we need to determine the cost per mile for each vehicle. The cost per mile is the cost per
gallon of gasoline divided by the miles per gallon, or:

Cost per mile for traditional = $3.25/21

Cost per mile for traditional = $0.154762

Cost per mile for hybrid = $3.25/29

Cost per mile for hybrid = $0.112069

So, the savings per mile driven for the hybrid will be:

Savings per mile = $0.154762 – 0.112069

Savings per mile = $0.042693

We can now determine the breakeven point by dividing the total additional cost by the savings
per mile, which is:

Total breakeven miles = $7,365 / $0.042693

Total breakeven miles = 172,511

So, the miles you would need to drive per year is the total breakeven miles divided by the
number of years of ownership, or:

Miles per year = 172,511 miles / 6 years

Miles per year = 28,752 miles/year

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b. First, we need to determine the total miles driven over the life of either vehicle, which will be:

Total miles driven = 6(15,000)

Total miles driven = 90,000

Since we know the total additional cost of the hybrid from part a, we can determine the
necessary savings per mile to make the hybrid financially attractive. The necessary cost savings
per mile will be:

Cost savings needed per mile = $7,365 / 90,000

Cost savings needed per mile = $0.08183

Now we can find the price per gallon for the miles driven. If we let P be the price per gallon,
the necessary price per gallon will be:

P/21 – P/29 = $0.08183

P(1/21 – 1/29) = $0.08183
P = $6.23

c. To find the number of miles it is necessary to drive, we need the present value of the costs and
savings to be equal to zero. If we let MDPY equal the miles driven per year, the breakeven
equation for the hybrid car as:

Cost = 0 = –$5,565 – $300(PVIFA10%,6) + $0.042693(MDPY)(PVIFA10%,6)

The savings per mile driven, $0.042693, is the same as we calculated in part a. Solving this
equation for the number of miles driven per year, we find:

$0.042693(MDPY)(PVIFA10%,6) = $6,871.58
MDPY(PVIFA10%,6) = 160,953.50
Miles driven per year = 36,956

To find the cost per gallon of gasoline necessary to make the hybrid break even in a financial
sense, if we let CSPG equal the cost savings per gallon of gas, the cost equation is:

Cost = 0 = –$5,565 – $300(PVIFA10%,6) + CSPG(15,000)(PVIFA10%,6)

Solving this equation for the cost savings per gallon of gas necessary for the hybrid to break
even from a financial sense, we find:

CSPG(15,000)(PVIFA10%,6) = $6,871.58
CSPG(PVIFA10%,6) = $0.45811
Cost savings per gallon of gas = $0.105184

Now we can find the price per gallon for the miles driven. If we let P be the price per gallon,
the necessary price per gallon will be:

P/21 – P/25 = $0.105184

P(1/21 – 1/25) = $0.105184
P = $8.01

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d. The implicit assumption in the previous analysis is that each car depreciates by the same dollar
amount and has identical resale value.

24. a. The cash flow per plane is the initial cost divided by the breakeven number of planes, or:

Cash flow per plane = $13,000,000,000 / 249

Cash flow per plane = $52,208,835

b. In this case the cash flows are a perpetuity. Since we know the cash flow per plane, we need to
determine the annual cash flow necessary to deliver a 20 percent return. Using the perpetuity
equation, we find:

PV = C /R
$13,000,000,000 = C / .20
C = $2,600,000,000

This is the total cash flow, so the number of planes that must be sold is the total cash flow
divided by the cash flow per plane, or:

Number of planes = $2,600,000,000 / $52,208,835

Number of planes = 49.80, or about 50 planes per year

c. In this case the cash flows are an annuity. Since we know the cash flow per plane, we need to
determine the annual cash flow necessary to deliver a 20 percent return. Using the present value
of an annuity equation, we find:

PV = C(PVIFA20%,10)
$13,000,000,000 = C(PVIFA20%,10)
C = $3,100,795,839

This is the total cash flow, so the number of planes that must be sold is the total cash flow
divided by the cash flow per plane, or:

Number of planes = $3,100,795,839 / $52,208,835

Number of planes = 59.39, or about 60 planes per year

Challenge

25. a. The tax shield definition of OCF is:

OCF = [(P – v)Q – FC ](1 – T) + TD

Rearranging and solving for Q, we find:

(OCF – TD)/(1 – T) = (P – v)Q – FC

Q = {FC + [(OCF – TD)/(1 – T)]}/(P – v)

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b. The cash breakeven is:

QC = $500,000/($40,000 – 20,000)
QC = 25

And the accounting breakeven is:

QA = {$500,000 + [($700,000 – $700,000(0.38))/0.62]}/($40,000 – 20,000)

QA = 60

The financial breakeven is the point at which the NPV is zero, so:

OCFF = $3,500,000/PVIFA20%,5
OCFF = $1,170,328.96

So:

QF = [FC + (OCF – T × D)/(1 – T)]/(P – v)

QF = {$500,000 + [$1,170,328.96 – .38($700,000)]/(1 – .38)}/($40,000 – 20,000)
QF = 97.93  98

c. At the accounting breakeven point, the net income is zero. Thus using the bottom up definition of
OCF:

OCF = NI + D

We can see that OCF must be equal to depreciation. So, the accounting breakeven is:

QA = {FC + [(D – TD)/(1 – T)]}/(P – v)

QA = (FC + D)/(P – v)
QA = (FC + OCF)/(P – v)

The tax rate has cancelled out in this case.

26. The DOL is expressed as:

DOL = %OCF / %Q

DOL = {[(OCF1 – OCF0)/OCF0] / [(Q1 – Q0)/Q0]}

The OCF for the initial period and the first period is:

OCF1 = [(P – v)Q1 – FC](1 – T) + TD

OCF0 = [(P – v)Q0 – FC](1 – T) + TD

The difference between these two cash flows is:

OCF1 – OCF0 = (P – v)(1 – T)(Q1 – Q0)

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Dividing both sides by the initial OCF we get:

(OCF1 – OCF0)/OCF0 = (P – v)( 1– T)(Q1 – Q0) / OCF0

Rearranging we get:

[(OCF1 – OCF0)/OCF0]/[(Q1 – Q0)/Q0] = [(P – v)(1 – T)Q0]/OCF0 = [OCF0 – TD + FC(1 – T)]/OCF0

DOL = 1 + [FC(1 – T) – TD]/OCF0

27. a. Using the tax shield approach, the OCF is:

OCF = [($280 – 185)(25,000) – $850,000](0.62) + 0.38($3,600,000/5)

OCF = $1,219,100

And the NPV is:

NPV = –$3,600,000 – 360,000 + $1,219,000(PVIFA13%,5)

+ [$360,000 + $500,000(1 – .38)]/1.135
NPV = $691,505.79

b. In the worst-case, the OCF is:

OCFworst = {[($280)(0.9) – 185](25,000) – $850,000}(0.62) + 0.38[$3,600,000(1.15)/5]

OCFworst = $826,140

And the worst-case NPV is:

NPVworst = –$3,600,000(1.15) – $360,000(1.05) + $826,140(PVIFA13%,5) +

[$360,000(1.05) + $500,000(0.85)(1 – .38)]/1.135
NPVworst = –$1,264,094.07

The best-case OCF is:

OCFbest = {[$280(1.1) – 185](25,000) – $850,000}(0.62) + 0.38[$3,600,000(.85)/5]

OCFbest = $1,612,060

And the best-case NPV is:

NPVbest = –$3,600,000(.85) – $360,000(0.95) + $1,612,060(PVIFA13%,5) +

[$360,000(0.95) + $500,000(1.15)(1 – .38)]/1.135
NPVbest = $2,647,105.64

28. To calculate the sensitivity to changes in quantity sold, we will choose a quantity of 26,000. The
OCF at this level of sale is:

OCF = [($280 – 185)(26,000) – $850,000](0.62) + 0.38($3,600,000/5)

OCF = $1,278,000

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The sensitivity of changes in the OCF to quantity sold is:

OCF/Q = ($1,219,100 – 1,278,000)/(25,000 – 26,000)

OCF/Q = +$58.90

The NPV at this level of sales is:

NPV = –$3,600,000 – $360,000 + $1,278,000(PVIFA13%,5) + [$360,000 + $500,000(1 – .38)]/1.135

NPV = $898,670.71

And the sensitivity of NPV to changes in the quantity sold is:

NPV/Q = ($691,505.79 – 898,670.71))/(25,000 – 26,000)

NPV/Q = +$207.16

You wouldn’t want the quantity to fall below the point where the NPV is zero. We know the NPV
changes $207.16 for every unit sale, so we can divide the NPV for 25,000 units by the sensitivity to
get a change in quantity. Doing so, we get:

$691,505.79 = $207.16(Q)
Q = 3,338

For a zero NPV, we need to decrease sales by 3,338 units, so the minimum quantity is:

QMin = 25,000 – 3,338

QMin = 21,662

29. At the cash breakeven, the OCF is zero. Setting the tax shield equation equal to zero and solving for
the quantity, we get:

OCF = 0 = [($280 – 185)QC – $850,000](0.62) + 0.38($3,600,000/5)

QC = 4,302

The accounting breakeven is:

QA = [$850,000 + ($3,600,000/5)]/($280 – 185)

QA = 16,526

From Problem 28, we know the financial breakeven is 21,662 units.

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30. Using the tax shield approach to calculate the OCF, the DOL is:

DOL = 1 + [$850,000(1 – 0.38) – 0.38($3,600,000/5)]/ $1,219,100

DOL = 1.2079

Thus a 1 percent rise leads to a 1.2079 percent rise in OCF. If Q rises to 26,000, then
the percentage change in quantity is:

Q = (26,000 – 25,000)/25,000 = .04, or 4%

So, the percentage change in OCF is:

%OCF = 4%(1.2079)
%OCF = 4.8314%

From Problem 26:

OCF/OCF = ($1,278,000 – 1,219,100)/$1,219,100
OCF/OCF = 0.048314, or 4.8314%

In general, if Q rises by 1,000 units, OCF rises by 4.8314%.

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