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ASSIGNMENT 2, FINANCIAL ECONOMICS SUMMER 2024

This assignment is on capital budgeting and risk. The report is due as indicated on Canvas. Follow the instructions listed at the end of this document. You can work in groups of up to three students.

To help you complete this assignment, you have two attached resources:

a. A capital budget Excel file. The file is similar to that discussed in class and serves as a template to complete the calculations and scenarios requested below.

b. Two instructional videos. One video reviews the capital budget cashflow setup to reinforce the concepts discussed in class; the other video explains how to perform scenario analysis in Excel using the Scenario Manager function.

Use these resources and the notes below to complete the required items.

Background

The template in the Excel file is a 7-year capital budgeting project for investment in new production equipment. Think of the original file as the “expected” scenario, which a former analyst completed before leaving the firm.

The company asks you to redo the analysis. Your manager says that the “expected” scenario completed by the previous analyst is not reasonable regarding timing and magnitude. So, your manager asks you to redo the “expected” scenario with several changes. In addition, your manager asks you to run several other scenarios.

Instructions

Your manager thinks the project should have a shorter life span, so the analysis needs to be redone based on a 5- year horizon instead of the initial 7-year horizon. So, instead of a time 0 investment followed by 6 years of cashflows and a final year 7 (termination year), the new analysis would include a time 0 investment followed by 4 years of cashflows and a final year 5 (termination year).

Adjust Expected Scenario Assumptions

In addition to the timing adjustment, the manager asks you to adjust the “expected” scenario as follows:

· The initial asset cost would still be $12,000, and the $4,000 expense at time 0 would remain the same.

· Revenues need to be adjusted 4% lower between years 1-4.

· Expenses need to be adjusted 5% lower between years 1-4.

· Working capital would be lower by 2% between years 1-4.

· As in the original version, the last year (in this case, year 5) would assume no revenues, expenses, or working capital. Year 5 is modeled only to capture the resale of the investment asset.

· The asset resale or disposition value in year 5 would be $4,000.

· The depreciation would continue to be straight-line over 6 years, with $2,000 depreciating yearly. Since the project horizon is now shorter, some book value would remain at the end of year 5.

· The tax rate of 21% would be the same.

· The discount rate would change to 11.5%.

· Any value not mentioned in the above notes will stay the same as the original file.

Additional Scenarios

Your manager wants to have four scenarios in total. You will use the Excel Scenario Manager function based on this information:

· The first (base) scenario is the “expected” scenario, with the revisions outlined above.

· The second scenario is a “better than expected” scenario, where:

o Revenues would be 10% higher every year than in the expected scenario.

o Expenses would be 5% lower yearly (years 1-4) than in the expected scenario.

o The discount rate would be 11%.

o No changes to anything else relative to the first (base), “expected” scenario.

· Third is an “adverse” scenario, where:

o Revenues would be 6% lower every year than in the expected scenario.

o Expenses would be 2% higher yearly (years 1-4) than in the expected scenario.

o The discount rate would be 12%.

o No changes to anything else relative to the first (base), “expected” scenario.

· The last scenario is an “extremely adverse” scenario, where:

o Revenues would be 12% lower every year than in the expected scenario.

o Expenses would be 5% higher every year (including year 0 and years 1-4) than in the expected scenario.

o The resale value of the asset would be $3,000 in year 5.

o The discount rate would be 12.5%.

o No changes to anything else relative to the first (base), “expected” scenario.

In all scenarios, the measure of interest (the one the manager wants to see how it varies) is the Net Present Value (NPV). The manager’s request also includes a table and a graphical comparison. Produce a table using the Scenario Manager function. You can use the instructional video attached to the assignment to complete the scenarios. Also, prepare a bar chart with the project’s probabilities on the y-axis and dollar NPV amounts on the horizontal axis.

The probabilities are 50% for the expected scenario, 30% for the better-than-expected scenario, 15% for the adverse scenario, and 5% for the extremely adverse scenario. Follow the steps in the instructional video.

Additional Questions

Your manager wants additional background and asks these questions, which you will respond to in writing. In preparing the answer, you can refer to materials or concepts discussed in class:

· Prepare a PDF document with the Excel calculations and short statements requested. Submit the PDF file. Do not submit the Excel file, just the PDF document showing your calculations and applicable explanations.

· When preparing the assignment, follow the rules concerning generative AI tools, like ChatGPT.

· If you have questions about the assignment, you can send them to the instructor by email. The instructor will respond and, when useful to the class, post the question with the answer in the Q&A section in Canvas.