Capital budgeting
Sensitivity Analysis
Probably the most important benefit of using a spreadsheet program is that it allows us to play “what-
if” games with the data. That is, we can experiment with different values to determine how our results
would change if there are changes in the assumptions.
Example
The Supreme Shoe Company is considering the purchase of a new, fully automated machine to replace
a manually operated one. The machine being replaced, now five years old, originally had an expected
life of 10 years, is being depreciated using the straight-line method from $40,000 down to $0 and can
now be sold for $22,000. It takes one person to operate the machine and he earns $29,000 per year in
salary and benefits.
The annual costs of maintenance and defects on the old machine are $6,000 and $4,000, respectively.
The replacement machine being considered has a purchase price of $75,000 and an expected salvage
value of $15,000 at the end of its five-year life. There will also be shipping and installation expenses of
$6,000. Because the new machine would work faster, investment in net working capital would increase
by a total of $3,000. The company expects that annual maintenance costs on the new machine will be
$5,000 while defects will cost $2,000.
Before considering this project, the company undertook an engineering analysis of current facilities to
determine if other changes would be necessitated by the purchase of this machine. The study cost the
company $5,000 and determined that existing facilities could support this new machine with no other
changes. In order to purchase the new machine, the company would have to take on new debt of
$30,000 at 10% interest, resulting in increased interest expense of $3,000 per year. The required rate
of return for this project is 15% and the company’s marginal tax rate is 34%. Furthermore, management
has determined that the maximum allowable time to recover its investment is three years.
The cashflow of Supreme Shoe Company is displayed in the file Scenariotemp.xlsx.
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Capital budgeting
1. NPV Profile Charts
One useful technique that we can use is referred to as the NPV profile. This is simply a chart of the NPV
at various discount rates. The analyst can determine, at a glance, how sensitive the NPV is to the
assumed discount rate. To create an NPV profile chart, we merely set up a range of discount rates and
NPV calculations and then create a chart.
To create an NPV profile chart for Supreme Shoe, let’s create a range of discount rates from 0% to 35%
in 5% increments. Move to cell A36 and enter: 0. To create the range of discount rates, select A36:A43
and then click Fill on the Home tab and then choose Series. In the dialog box, change the Step Value to:
0.05 (you could type 5% instead) and then click the OK button. You should now have a range of discount
rates from 0% to 35%. We will use these rates in our NPV calculations.
To calculate the NPV at each discount rate, enter: =NPV(A36,D$20:D$24)+D$19 in B36. This is exactly
the same formula as in B27, except that we have added a few dollar signs to freeze the references and
we changed the discount rate to reference A36. Copying this formula to B37:B43 will calculate the NPV
at each discount rate. Note that the NPV becomes negative at a discount rate somewhere between 30%
and 35%. Of course, we knew
this already because the IRR is 30.95%.
Finally, to create the chart select the A35:B43 and insert a scatter chart with straight lines. This section
of your worksheet should resemble the one in Exhibit below:
Notice that the chart clearly shows the IRR is just over 30%. This is the point where the NPV line
crosses the x axis of the NPV profile chart. Furthermore, it is obvious that for any discount rate below
30% the project has a positive NPV; thus it is acceptable. In fact, it is obviously acceptable at any
reasonable discount rate.
Typically, an NPV profile chart is used to compare two mutually exclusive projects.
Whenever there is a ranking conflict, the NPV profiles will cross at a rate at which the firm would be
indifferent between the two projects. You can try this by entering the data for projects A and B from
Table below and then creating an NPV profile chart for the projects.
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Capital budgeting
This “crossover rate,” where the NPVs are the same, can be found by calculating the IRR of the
difference between the cash flows of the two projects. If you placed the cash flows for the projects
into B2:C7, then this formula will calculate the crossover rate: =IRR(B2:B7–C2:C7).
Scenario Analysis
Excel contains a very powerful tool called the Scenario Manager that helps in analyzing the effects of
different assumptions. Scenario Manager can be used to toggle your worksheet between various
alternative scenarios, or it can create a summary of the effects of changing the assumptions.
As an example, we will create three scenarios in which the estimates of maintenance and defect costs
are different than expected. The three scenarios are listed in the Table below.
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Capital budgeting
In the Best Case scenario, both maintenance and defects are lower than those in the Expected Case
(which represents the original estimates). In the Worst Case, both are higher than expected. Because
we are going to be changing our assumed values for maintenance and defects, it will be helpful to first
define range names for these cells. Select C14 and then click the Formulas tab and choose Define Name.
Assign the name Maintenance to this cell, give a worksheet-level scope, and enter a comment about its
purpose. Now define the name Defects for cell C15 (see page 10 for a discussion of named ranges).
The Scenario Manager can be found by clicking the What-If Analysis button on the Data tab. Because no
scenarios are defined at this point, the first dialog box will ask you to click the Add button to define your
scenarios. In this case, we want the maintenance and defect estimates to change, so click the Add button
and then enter: Best Case for the scenario name. Click in the Changing cells edit box, highlight cells
C14:C15, and then click the OK button.
The next dialog box will ask you to supply the new values for the changing cells like in Figure 11-7. In the
edit box labeled “Maintenance:” enter: 2000 and in the edit box labeled “Defects:” type: 1000. Note
that this dialog box prompts you for the values using the names that we earlier defined for these cells.
If you didn’t define the names, then you will be prompted with the cell addresses instead of names.
Click the Add button to enter the next scenario. Now, repeat these steps for the other two cases using
the names “Expected Case” and “Worst Case” and the appropriate values from Table 5.
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Capital budgeting
The Figure below shows how the dialog box will look when you have entered all three scenarios.
At this point, you can change the worksheet to display the scenario of your choice by highlighting the
name of the case and clicking the Show button. For example, if you highlight “Worst Case” and click the
Show button, the maintenance and defect cells will change and the worksheet will update. You can now
see the effects of these changes on the cash flows and profitability measures (e.g., the NPV is $14,277.70
under the Worst Case scenario). Return to the original data by choosing “Expected Case” from the list
and pressing the Show button. This type of flexibility is one of the promised results of proper worksheet
design. Scenario analysis will not work properly unless you are diligent about using formulas, rather than
retyping values, whenever possible.
It would be nice to see a summary of the different scenarios, and we can do just that. But first, exit from
the Scenario Manager and define a name for each cell in B25:B30 so that the output will be easier to
understand. Now, bring back the Scenario Manager and click the Summary button. When the Scenario
Summary dialog box appears, select cells B25:B30 for the Result cells and click OK. Excel will then
automatically create a new worksheet that displays the changed values and the resulting profitability
measures. Exhibit 11-6 shows the summary worksheet.
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Capital budgeting
We have defined three simple scenarios, but other problems may require more scenarios or more
changing variables. You can define as many scenarios as your PC’s memory will hold, but only the first
251 will be displayed on the scenario summary worksheet. There is also a limit of 32 changing cells per
scenario.
Example 2: I’d like to create best, worst, and most-likely scenarios for the sales of an automobile by varying
the values of Year 1 sales, annual sales growth, and Year 1 sales price.
The Original Model worksheet in the file NPVaudit.xlsx contains calculations that compute the NPV of
after-tax profits for a car expected to be available from the manufacturer for five years.
Suppose you want to create the following three scenarios related to the net present value (NPV) of a
car:
For each scenario, you want to look at the firm’s NPV and each year’s after-tax profit. The work is in the
file NPVauditscenario.xlsx. Figure 1 shows the worksheet model (contained in the Original Model
worksheet).
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Capital budgeting
FIGURE 1 The data on which the scenarios are based.
To begin defining the best-case scenario, while in the Original Model worksheet, display the Data tab,
and then click Scenario Manager on the What-If Analysis menu in the Forecast group. Then click the Add
button, and fill in the Add Scenario dialog box as shown in Figure 3.
FIGURE 3 Data inputs for the best-case scenario.
Enter the scenario name as Best, and select or enter cells C2:C4 as the changing cells, which contain
the values that define the scenario. After you click OK in the Add Scenario dialog box, fill in the
Scenario Values dialog box with the input values that define the best case, as shown in Figure 4.
FIGURE -4 Defining the input values for the best-case scenario.
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Capital budgeting
For the Best scenario, I entered 2000 as the value in Year1sales, 0.2 in Sales_growth, and 10 in
Year1price. By clicking Add in the Scenario Values dialog box (which isn’t available when you edit a
scenario), you can enter the data for the most-likely and worst-case scenarios as well. After clicking Add
and entering data for all three scenarios (Best, Most Likely, and Worst), click OK in the Scenario Values
dialog box. The Scenario Manager dialog box, shown in
Figure 5, lists the scenarios I created.
When you click Summary in the Scenario Manager dialog box, you can enter in the Result Cells box the
cells that will be displayed in the scenario reports. Figure 6 shows how I indicated in the Scenario
Summary dialog box that I want the scenario summary report to track each year’s after-tax profit (cells
B17:F17) as well as the total NPV (cell B19).
FIGURE 6 Using the Scenario Summary dialog box to select the result cells for the summary
report.
Because the result cells come from more than one range, I separated the ranges B17:F17 and B19 with
a comma. (I could also have used the Ctrl key to select and enter multiple ranges.) After you select
Scenario Summary (instead of the PivotTable option) and click OK, Excel creates the beautiful Scenario
Summary report pictured earlier in Figure 2. In the Scenario Summary worksheet, notice that Excel
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Capital budgeting
includes a column, labeled Current Values, for the values that were originally placed in the worksheet.
The worst case loses money (a loss of $13,345.75), whereas the best case is quite profitable (a profit of
$226,892.67). Because the worst-case price is less than our variable cost, the worst case loses money in
each year.
Problems
1. Delete the best-case scenario and run another scenario report.
2. Add a scenario named High Price, in which Year 1 price equals $15 and the other two inputs
remain at their most-likely values.
3. For the lemonade stand example in EX_3.xlsx use the Scenario Manager to display a report
summarizing profit for the following scenarios:
4. For the mortgage-payment example in in EX_4.xlsx, use the Scenario Manager to create a report
tabulating monthly payments for the following scenarios:
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Capital budgeting
1. Ferrous Supplies, Inc., a manufacturer of finished steel products from recycled metals and
recycled ferrous and non-ferrous metal and auto parts, is evaluating two mutually exclusive
investment projects. Cash flows of each project are displayed in the file FerrousTemp.xlsx.
▪ Calculate the payback period, discounted payback period, NPV, PI, IRR and MIRR of each
investment project. Should the firm accept or reject one or both projects?
▪ The firm’s management has decided to reconsider some estimated variables and has
determined the following three possible scenarios:
Equipment Costs Salvage Value Variable Costs
Auto Auto Auto
Exhaust Exhaust Exhaust
Scenarios Wheels Systems Wheels Systems Wheels Systems Inflation
Best Case 2.2M 1.4M 750K 170K 65% 55% 2%
Base Case 2.4M 1.5M 700K 150K 70% 60% 3%
Worst Case 2.5M 1.6M 650K 120K 72% 65% 4%
▪ Create a scenario analysis showing the payback period, discounted payback period, NPV,
PI, IRR and MIRR using the information in the table above. Which project should be
selected under which scenario?
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