Bauer Industries is an automobile manufacturer. Management



Bauer Industries is an automobile manufacturer. Management

Bauer Industries is an automobile manufacturer. Management
is currently evaluating a proposal to build a plant that will manufacture
lightweight trucks. Bauer plans to use a cost of capital of 12% to evaluate
this project. Based on extensive research, it has prepared the following
incremental free cash flow projections (in millions of dollars):

Year Years 1
Year 10

0 -9 10

100.0 100.0

Manufacturing expenses (other than depreciation) -35

Marketing expenses
-10 -10

Depreciation -15 -15

=EBIT 40 40

-Taxes (35%) -14 -14

= Unlevered Net Income
26 26

+Depreciation +15 +15

-Increases in net working capital -5 -5

-Capital Expenditures

+Continuation value

=Free Cash Flow
-150 36 48

• a. For this
base-case scenario, what is the NPV of the plant to manufacture lightweight

• b. Based
on input from the marketing department, Bauer is uncertain about its revenue
forecast. In particular, management would like to examine the sensitivity of the
NPV to the revenue assumptions. What is the NPV of this project if revenues are
10% higher than forecast? What is the NPV if revenues are 10% lower than

• c. Rather
than assuming that cash flows for this project are constant, management would
like to explore the sensitivity of its analysis to possible growth in revenues
and operating expenses. Specifically, management would like to assume that
revenues, manufacturing expenses, and marketing expenses are as given in the
table for year 1 and grow by 2% per year every year starting in year 2.
Management also plans to assume that the initial capital expenditures (and
therefore depreciation), additions to working capital, and continuation value
remain as initially specified in the table. What is the NPV of this project
under these alternative assumptions? How does the NPV change if the revenues
and operating expenses grow by 5% per year rather than by 2%?

• d. To
examine the sensitivity of this project to the discount rate, management would
like to compute the NPV for different discount rates. Create a graph, with the
discount rate on the x-axis and the NPV on the y-axis, for discount rates
ranging from 5% to 30%. For what ranges of discount rates does the project have
a positive NPV?


You are considering making a movie. The movie is expected to
cost $10 million upfront and take a year to make. After that, it is expected to
make $5 million when it is released in one year and $2 million per year for the
following four years. What is the payback period of this investment? If you
require a payback period of two years, will you make the movie? Does the movie
have positive NPV if the cost of capital is 10%?

Choosing Between Projects


You are deciding between two mutually exclusive investment
opportunities. Both require the same initial investment of $10 million.
Investment A will generate $2 million per year (starting at the end of the
first year) in perpetuity. Investment B will generate $1.5 million at the end
of the first year and its revenues will grow at 2% per year for every year
after that.


Which investment has the higher IRR?


Which investment has the higher NPV when the cost of capital
is 7%?


In this case, for what values of the cost of capital does
picking the higher IRR give the correct answer as to which investment is the
best opportunity?

Pisa Pizza, a seller of frozen pizza, is considering
introducing a healthier version of its pizza that will be low in cholesterol
and contain no trans fats. The firm expects that sales of the new pizza will be
$20 million per year. While many of these sales will be to new customers, Pisa
Pizza estimates that 40% will come from customers who switch to the new,
healthier pizza instead of buying the original version.


Assume customers will spend the same amount on either
version. What level of incremental sales is associated with introducing the new


Suppose that 50% of the customers who will switch from Pisa
Pizza’s original pizza to its healthier pizza will switch to another brand if
Pisa Pizza does not introduce a healthier pizza. What level of incremental
sales is associated with introducing the new pizza in this case?


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