Question

Project Analysis: You are considering a new product launch. The project will cost $760,000, have a four year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 420 units per year; price per unit will be $17,200; variable cost per unit will be $14,300; and fixed costs will be $640,000 per year. The required return on the project is 15 percent, and the relevant tax rate is 35 percent.

a. Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within +- 10 percent. What are the upper and lower bounds for these projections? What is the base case NPV? What are the best case and worst case scenarios?

b. Evaluate the sensitivity of your base case NPV to changes in fixed costs.

c. What is the accounting break even level of output for this project?

Answer 1

	0	1	2	3	4
Investment	-760,000
Sales		7,224,000	7,224,000	7,224,000	7,224,000
VC		-6,006,000	-6,006,000	-6,006,000	-6,006,000
FC		-640,000	-640,000	-640,000	-640,000
Depreciation		-190,000	-190,000	-190,000	-190,000
EBT		388,000	388,000	388,000	388,000
Tax (35%)		-135,800	-135,800	-135,800	-135,800
Profit		252,200	252,200	252,200	252,200
Cash Flows	-760,000	442,200	442,200	442,200	442,200
NPV	$502,471.43

The above is the base case NPV.

In best case scenario, Unit sales = 420 x 1.10 = 462, VC = 0.9 x 14,300 = 12,870, FC = 640,000 x 0.9 = 576,000

=> NPV = $2,073,277.67

In worst case scenario, unit sales = 420 x 0.9 = 378, VC = 1.1 x 14,300 = 15,730, FC = 640,000 x 1.1 = 704,000

=> NPV = -845,423.81

b) Sensitivity to fixed cost can be calculated by calculating change in NPV increasing FC by $1

If FC = 640,001 => NPV = $502,469.58

=> Sensitivity = $1.86 - difference in NPV.

c) Accounting break even level = (FC + Depreciation) / (P - VC) = (640,000 + 190,000) / (17,200 - 14,300) = 286