Ocf T X D

1 - T P - v b. Use the expression in part (a) to find the cash, accounting, and financial break-even points for the Wettway sailboat example in the chapter. Assume a 38 percent tax rate.

c. In part (b), the accounting break-even should be the same as before. Why? Verify this algebraically.

Operating Leverage and Taxes Show that if we consider the effect of taxes, the degree of operating leverage can be written as:

0. Can you interpret this in

Notice that this reduces to our previous result if T words?

Scenario Analysis Consider a project to supply Detroit with 35,000 tons of machine screws annually for automobile production. You will need an initial $1,500,000 investment in threading equipment to get the project started; the project will last for five years. The accounting department estimates that annual fixed costs will be $300,000 and that variable costs should be $200 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the five-year project life. It also estimates a salvage value of $500,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $230 per ton. The engineering department estimates you

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

11. Project Analysis and Evaluation

© The McGraw-Hill Companies, 2002

PART FOUR Capital Budgeting

Challenge

(continued)

Spreadsheet Templates 11-5, 11-17, 11-25

will need an initial net working capital investment of $450,000. You require a 13 percent return and face a marginal tax rate of 38 percent on this project.

a. What is the estimated OCF for this project? The NPV? Should you pursue this project?

b. Suppose you believe that the accounting department's initial cost and salvage value projections are accurate only to within ±15 percent; the marketing department's price estimate is accurate only to within ±10 percent; and the engineering department's net working capital estimate is accurate only to within ± 5 percent. What is your worst-case scenario for this project? Your best-case scenario? Do you still want to pursue the project?

26. Sensitivity Analysis In Problem 25, suppose you're confident about your own projections, but you're a little unsure about Detroit's actual machine screw requirement. What is the sensitivity of the project OCF to changes in the quantity supplied? What about the sensitivity of NPV to changes in quantity supplied? Given the sensitivity number you calculated, is there some minimum level of output below which you wouldn't want to operate? Why?

27. Break-Even Analysis Use the results of Problem 23 to find the accounting, cash, and financial break-even quantities for the company in Problem 25.

28. Operating Leverage Use the results of Problem 24 to find the degree of operating leverage for the company in Problem 25 at the base-case output level of 35,000 units. How does this number compare to the sensitivity figure you found in Problem 26? Verify that either approach will give you the same OCF figure at any new quantity level.

Spreadsheet Templates 11-5, 11-17, 11-25

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