Assignment 2: LASA 1: NPV, Sensitivity, Risk, Bias and Ethics in Capital Budgeting
Investment projects should never be selected through purely mechanical processes. Managers should ask questions about the positive net present value (NPV). Good managers realize that the forecasts behind NPV calculations are imperfect. Therefore, they explore the consequences of a poor forecast and check whether it is worth doing more homework. They use several different tools and analysis techniques to answer their “what-if” questions.
In addition, managers should consider the types of bias, both unintentional and intentional, that may enter into the capital budgeting analysis. As part of this assignment, you will examine the potential motivation for unethical behavior by executives that may take place in the capital budgeting process and explain how biasing cash-flow estimates can work to the advantage of the executive who intentionally inserts such bias.
Assume that you are employed by a wood milling company that is evaluating the desirability of adding a new product to their product mix. The product would require the addition of new and different CNC (computer numerical control) milling equipment. Your boss has asked you to analyze a project proposal and recommend whether the project should be accepted or rejected. The most likely project estimates are:
- Unit selling price = $50
- Unit variable cost = $30
- Total fixed costs including depreciation = $300,000
- Expected sales = 30,000 units per year
The projects will last for 10 years and will require an initial investment of $1 million, which will be depreciated straight-line over the project life to a final value of zero. The firm’s tax rate is 35% and the required rate of return is 12%.
Your boss recognizes that some of these estimates are subject to error and wants to better understand the risks associated with the project and alternatives for dealing with those risks. You have been asked to include a sensitivity analysis in your report. You are also to explain how changing the discount rate might be helpful.
Your boss has heard about cash flow estimates being biased for personal gain at the company’s expense in another firm and would like to better understand that potential problem. You have been asked to address that in your report.
The team developing the proposal estimated that variable cost and sales volume may each turn out to be as much as 10% higher or 10% lower than the initial estimate. To complete this assignment, you are to submit a four to five page paper that includes the following:
Using MS Excel:
- Calculate the project’s NPV for the most likely results.
- Calculate the project’s NPV for the best-case scenario.
- Calculate the project’s NPV for the worst-case scenario.
- Calculate the project IRR for the most likely results.
You will transfer your calculations into your final report. In a 4-5 page paper in MS Word:
- Exhibit your Excel function entries and results, or your calculations using present value tables, for each of your NPV and IRR calculations (A-D) and provide an explanation of all calculations
- Explain your recommendation regarding whether the project should be accepted and a justification of your response.
- Provide an explanation of how adjusting the discount rate in the basic NPV model of capital budgeting deals with the problem of project risk.
- Examine the potential motivation for unethical behavior by executives that may take place in the capital budgeting process and explain how biasing cash-flow estimates can work to the advantage of the executive who intentionally inserts such bias.