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# NPV and IRR Sensitivity Analysis

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The chapter opener talked about Diamond Comic Distributor's attempt to reduce the cost of opening a retail comic book store. Suppose that the current cost of opening such a store is \$400,000 and that \$250,000 of that initial investment is the cost of stocking the shelves with new inventory. Suppose also that the annual operating cash inflow from running an average comic book store is about \$62,000 before taxes and that the tax rate is 35%.

a. Assuming that the average comic book store has a life of about 10 years, what is the NPV of opening a new store if the required rate of return in this business is 10%? You may assume that the \$250,000 in initial inventory will be recovered at the end of the tenth year (in addition to the annual operating cash flow for that year). What is the IRR that one can earn by opening up a new store?

b. Assume that by offering merchandise discounts to customers who are opening new stores Diamond can reduce the required initial inventory investment from \$250,000 to \$150,000. Maintaining all other assumptions as previously stated, how will that affect the NPV and IRR earned on a new comic book store?

#### Solution Summary

This solution illustrates how to perform a sensitivity analysis by changing the initial net working capital investment and subsequent recovery and the how to compute the effect of that change on net present value and internal rate of return. Additionally, it illustrates how to use Excel's NPV and IRR functions.

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## Compute free cash flow, initial outlay, terminal cash flow, NPV, IRR. Discuss project risk, CAPM, simulations and sensitivity analysis.

Using data in the attached excel file, respond to these:

Should the company focus on cash flows or accounting profits in making its capital-budgeting decisions? Should the company be interested in incremental cash flows,
incremental profits, total free cash flows, or total profits?

b.
How does depreciation affect free cash flows?

c.
How do sunk costs affect the determination of cash flows?

d.
What is the projects initial outlay?

e.
What are the differential cash flows over the projects life?

f.
What is the terminal cash flow?

g.
Draw a cash flow diagram for this project?

h.
What is its net present value?

i.
What is its internal rate of return?

j.
Should the project be accepted? Why or why not?

k.
In capital budgeting, risk can be measured from three perspectives. What are those three measures of a projects risk?

l.
According to CAPM, which measurements of a projects risk is relevant? What complications does reality introduce into the CAPM view of risk, and what does that
mean for our view of the relevant measure of a projects risk?

m.
Explain how simulation works. What is the value in using a simulation approach?

n.
What is sensitivity analysis and what is its purpose?

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