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

ProjecInitial investment = Equipment Cost + working capital = 3,500,000 + 850,000 =  4,350,000

Terminal cash flow = Post tax salvage value + release of working capital = 500,000 x (1 - 30%) + 850,000 = 1,200,000

Please see the table below. All financials are in $. Please see the second column to understand the mathematics. The last row colored in yellow contains your answer.

	Linkage	Base Case	Worst Case	Best Case
Initial investment	A	4,350,000	4,350,000	4,350,000
Life	B	4.00	4.00	4.00
Sale Price per unit	C	22.00	22 x (1 - 20%) = 17.60	22 x (1 + 20%) = 26.40
Sale volume	D	650,000	650,000 x (1 - 20%) = 520,000	650,000 x (1 + 20%) = 780,000
Variable cost per unit	E	17.00	17.00 x (1 + 20%) = 20.40	17.00 x (1 - 20%) = 16.32
Cash fixed cost	F	450,000	450,000 + 100,000 = 550,000	450,000 - 100,000 = 350,000
Annual depreciation	G = 3,500,000/B	875,000	875,000	875,000
EBIT	H = (C - E) x D - F - G	1,925,000	-2,881,000	6,637,400
Taxes	I = H x 30%	577,500	-864,300	1,991,220
NOPAT	J = H - I	1,347,500	-2,016,700	4,646,180
OCF	K = J + G	2,222,500	-1,141,700	5,521,180
Terminal Cash flows	L	1,200,000	1,200,000	1,200,000
Discount rate	M	10%	10%	10%
NPV	'=-PV(M,B,K,L)-A	3,514,642.10	-7,149,419.23	13,971,013.85

Project's NPV is highly sensitive to the operating parameters such as sales price, sales volume, variable cost per unit and fixed cost. In the worst cse scenario, the project has a negative NPV.