Information needed to answer:

Big B Coffee Roaster is considering replacing one of its existing machines with a new, more automated and efficient machine. The old machine was bought five years ago for $93,750. It is being depreciated on a straight-line basis over a fifteen-year life. The machine could be sold today at $20,000. The new machine will cost $96,000 and its depreciable life is ten years with a salvage value of $13,000. However, in accordance with U.S. tax law, the asset will be depreciated down to zero over the ten years via the straight-line method. In 2009, Big Bs existing coffee roasting machine accounted for annual revenues (sales) of $50,000 and had annual operating costs of $25,000. The new machine will increase this revenue to $72,000 per year. The machine will also increase operating costs by $3,000 per year. Finally, the new machine requires that the company raises its inventory of green coffee beans by $4,000. The cost of capital for Big B is 14% and the corporate tax rate is 40%. Big B has profitable ongoing operation that can be used to offset losses.

New Problem:

The managers of Big B now realize that some of the base case assumptions they made are not totally correct. Specifically, the increase in revenues and operating costs are unpredictable. The same is true for the salvage value of the new equipment at the end of its life (10 years from today). Even though projected increase in operating costs is $3,000, experience from other companies using the same equipment indicates that operating costs vary significantly from year to year. One of Big Bs cost analysts has come to the conclusion that increase in operating costs will follow a normal distribution with a mean of $5,000 and a standard deviation of $500. Increase in revenues will depend on the overall state of the economy in a given year. Analysts believe that the increase in sales is not going to be less than $18,000 but if the economy is in good state the increase in sales can reach as much as $27,000. Big Bs analysts have decided to use a uniform distribution with a minimum of $18,000 and a maximum of $27,000 to model the increase in sales variable. Finally, the actual salvage value of the new equipment at the end of its life is most likely going to be $13,000 but it could range from $5,000 to $20,000 depending on the technological advancements in the industry. Big Bs analysts have decided to use a triangular distribution to model the sale price of the new equipment in 10 years. Big B wants to evaluate how these uncertainties might affect their decision to buy or not the new equipment. They want to find out what the expected NPV and IRR of the project are, which variables have the biggest effect on them and what they can do to limit the uncertainty. Use @Risk to run a simulation and provide answers to the following questions. Make sure that you create and include the full report of the simulation to the files you post online and justify your answers (name the workbook Simulation 1 results). Remember that each year should be modeled independently of the rest. Use 10,000 trials for each simulation. a) What are the expected NPV and IRR? b) What is the probability of getting a negative NPV? c) What is the most important source of uncertainty? d) How important is the actual sale price of the equipment at the end of year 10? QUESTION 2 (1 POINT): Assume the company that is selling the equipment is offering the following service plan with their equipment: If the operating costs in a given year exceed $5,100 they will pay for the additional costs. For example, if the operating costs in a given year are $5,300 then they are

going to give Big B $200, if the costs are $5,150 then they will give Big B $50. If the operating costs turn out to be $4,800 then nothing happens. Incorporate this adjustment in your model (you will need to use the IF function), re-run the simulation and answer the following questions. Include a copy of the simulation report in the files you post (name this workbook Simulation 2 results). a) What is the expected NPV with the service plan? b) What is the probability of getting a negative NPV? Does it improve compared to Q2? c) How much would you be willing to pay for a service plan like this and why?