Question

Case Study: Assume that the company, where you are working as a team in Financial Department, is considering a potential project with a new product that is expected to sell for an average price of $22 per unit and the company expects it can sell 650 000 unit per year at this price for a period of 4 years. Launching this project will require purchase of a $3 500 000 equipment that has residual value in four years of $500 000 and adding $ 850 000 in working capital which is expected to be fully retrieved at the end of the project. Other information is available below: Depreciation method: straight line Variable cost per unit: $17 Cash fixed costs per year: $450 000 Discount rate: 10% Tax Rate: 30% Do a scenario analysis with cash flows of the assumed project to determine the sensitivity of the project’s NPV to different scenarios that are defined in terms of the estimated values for each of the project’s value drivers. Please work on two scenarios corresponding to the worst- and best-case outcomes for the project. You need to provide your results in (a) relevant tables: Worst case: Unit sales decrease by 20%; price per unit decreases by 20%; variable cost per unit increases by 20 %; cash fixed cost per year increases by $100 000 Best case: Unit sales increase by 20%; price per unit increases by 20%; variable cost per unit decreases by 20%; cash fixed cost per year decreases by $100 000 Based on the scenario analysis outcome, draw relevant conclusion about project NPV’s sensitivity.

Answer 1

NPV in the neutral case = ΣPresent value of cashflow = 3,515,267.

Sl No	Years	0	1	2	3	4
i	Sales revenue (650000*22)		14,300,000	14,300,000	14,300,000	14,300,000
ii	Variable cost (650000*17)		11,050,000	11,050,000	11,050,000	11,050,000
iii	Fixed cost (given)		450,000	450,000	450,000	450,000
iv	EBITDA (i-ii-iii)		2,800,000	2,800,000	2,800,000	2,800,000
v	Depreciation (3500000/4)		875,000	875,000	875,000	875,000
vi	EBIT (iv-v)		1,925,000	1,925,000	1,925,000	1,925,000
vii	Tax @ 30% (vi*0.3)		577,500	577,500	577,500	577,500
viii	EBIAT (vi-vii)		1,347,500	1,347,500	1,347,500	1,347,500
ix	Add back: Depreciation		875,000	875,000	875,000	875,000
x	Operating cashflow (viii+ix)		2,222,500	2,222,500	2,222,500	2,222,500
xi	Cost of equipment (given)	-3,500,000
xii	Sale of equipment after tax (500000*70%)					350,000
xiii	Working capital (given)	-850,000				850,000
xiv	Net cashflow (x+xi+xii+xiii)	-4,350,000	2,222,500	2,222,500	2,222,500	3,422,500
xv	PVF @ 10% (1/1.1^year)	1	0.9091	0.8265	0.7514	0.6831
xvi	Present value of cash flow (xiv*xv)	-4,350,000	2,020,475	1,836,896	1,669,987	2,337,910

a) NPV in worst case = -7,149,583

Sl No	Years	0	1	2	3	4
i	Net cashflow from table 1	-4,350,000	2,222,500	2,222,500	2,222,500	3,422,500
ii	Loss of unit sales (650000*20%*22)		-2,860,000	-2,860,000	-2,860,000	-2,860,000
iii	Loss due to fall in price (650000*80%*22*20%)		-2,288,000	-2,288,000	-2,288,000	-2,288,000
iv	Variable cost saved due to unit loss (650000*20%*17)		2,210,000	2,210,000	2,210,000	2,210,000
v	Loss due to variable cost increases (650000*80%*17*20%)		-1,768,000	-1,768,000	-1,768,000	-1,768,000
vi	Loss due to fixed cost increases (given)		-100,000	-100,000	-100,000	-100,000
vii	Incremental EBIT (ii+iii+iv+v+vi)		-4,806,000	-4,806,000	-4,806,000	-4,806,000
viii	Tax @ 30% (vii*30%)		-1,441,800	-1,441,800	-1,441,800	-1,441,800
ix	Incremental EBIAT (vii-viii)		-3,364,200	-3,364,200	-3,364,200	-3,364,200
x	Net cashflow (i+ix)	-4,350,000	-1,141,700	-1,141,700	-1,141,700	58,300
xi	PVF @ 10% (1/1.1^year)	1	0.9091	0.8265	0.7514	0.6831
xii	Present value of cash flow (x*xi)	-4,350,000	-1,037,919	-943,615	-857,873	39,825

b) NPV in best case = 18,680,392

No	Years	0	1	2	3	4
i	Net cashflow from table 1	-4,350,000	2,222,500	2,222,500	2,222,500	3,422,500
ii	Increase in sales due to increase in unit sales (650000*20%*22)		2,860,000	2,860,000	2,860,000	2,860,000
iii	Increase in sales due to increase in selling price (650000*120%*22*20%)		3,432,000	3,432,000	3,432,000	3,432,000
iv	Increase in variable cost due to increase in unit sales (650000*20%*-17)		-2,210,000	-2,210,000	-2,210,000	-2,210,000
v	Decrease in variable cost due to fall in variable cost (650000*1.2*17*0.2)		2,652,000	2,652,000	2,652,000	2,652,000
vi	Decrease in cash fixed cost (Given)		100,000	100,000	100,000	100,000
vii	Incremental EBIT (ii+iii+iv+v+vi)		6,834,000	6,834,000	6,834,000	6,834,000
viii	Tax @ 30% (vii*30%)		2,050,200	2,050,200	2,050,200	2,050,200
ix	Incremental EBIAT (vii-viii)		4,783,800	4,783,800	4,783,800	4,783,800
x	Net cashflow (i+ix)	-4,350,000	7,006,300	7,006,300	7,006,300	8,206,300
xi	PVF @ 10% (1/1.1^year)	1	0.9091	0.8265	0.7514	0.6831
xii	Present value of cash flow (x*xi)	-4,350,000	6,369,427	5,790,707	5,264,534	5,605,724