Question

Question 2 25 Marks
Kavango Ltd is considering investing in a project at a cost of N$3 000 000. The estimated economic life of the project is 5 years. The company will use the straight-line method to depreciate the cost of the project over 5 years. The company estimates that sales will amount to 240 000 units per year at an estimated selling price of N$40 per unit. The company expects to incur fixed overheads, excluding depreciation of N$300 000 per year and variable cost per unit isN$30. The company cost of capital is 11% and the corporate tax rate is 28%. The expected residual value of the project in 5 years’ time is expected to be zero.
Required:
a) Use the sensitivity analysis to determine what the NPV of the project would be if selling price, sales volume, and variable cost per unit are increased or reduced by 10%.

b) Use break-even analysis to determine the minimum sales volume that the company is required to achieve to break-even in terms of NPV.

Answer 1

a]

Operating cash flow (OCF) of each year = income after tax + depreciation

depreciation each year = initial cost / project life = $3,000,000 / 5 = $600,000

NPV is calculated using NPV function in Excel

The base-case NPV is $3,209,107

If selling price is increased by 10%, NPV is $5,763,711

If selling price is decreased by 10%, NPV is $654,503

If sales volume is increased by 10%, NPV is $3,847,758

If sales volume is decreased by 10%, NPV is $2,570,456

If variable cost is increased by 10%, NPV is $846,098

If variable cost is decreased by 10%, NPV is $4,294,814

b]

The sales volume at which NPV becomes zero is the break-even sales volume

By trial-and-error, we can see that the NPV becomes zero at 119,405 of sales volume