Question

Buffy the Vampire Slayer is creating her own slaying company. All the trademarks cost her $150,000 today but she’s sure it’ll pick up soon. Best case scenario, next year she’ll be earning $75,000 and then $50,000 in years 2 and 3, followed by $90,000 in years 4 and 5. These numbers are, of course, dependent on vampire slaying needs in the community. There is a worst case scenario where she only earns $35,000 in the first 3 years then $40,000 in the next 2. The most likely outcome though is earning $45,000 in the first year, $50,000 in year 2, $60,000 in year 3, then $50,000 in year 4, and $45,000 in year 5. If the relevant interest rate was 15%, would you recommend the project? Why or why not?

(Use Excell and use your knowledge about NPV, IRR, and scenario analysis method)

Answer 1

We have three scenarios here which we will solve independently. The initial outlay in each is 150,000. Using the Net Present Value formula, for the best case scenario we have:

NPV = -150,000 + 75000/1.15 + 50000/1.15^2 + 50000/1.15^3 + 90000/1.15^4 + 90000/1.15^5

NPV = 82104

Similarly, for the worst case scenario,

NPV = -150000 + 35000/1.15 + 35000/1.15^2 + 35000/1.15^3 +40000/1.15^4 + 40000/1.15^5

NPV = -27330

And for the most likely scenario:

NPV = -150000 + 45000/1.15 + 50000/1.15^2 + 60000/1.15^3 + 50000/1.15^4 +45000/1.15^5

NPV = 17349

Hence, we see that it is profitable to take up the project for the most likely and the best case scenario but not for the worst case scenario as the NPV in that case is negative. Therefore, the decision depends on the likelyhood of the three scenrios. If we assume equal probability of each scenario we get the equivalent NPV as: (82104 + 17349 - 27330)/3 = 24041. Hence, we can take up the project if the probability is 1/3rd of each scenario