Question

Part 3: Risk analysis and project evaluation
3.1 Perform a scenario analysis on the data provided
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 worstand 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 Part 3: Risk analysis and project evaluation
3.1 Perform a scenario analysis on the data provided
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 worstand 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

Answer 1

In order to perform the sesitivity analysis we need to analyze the cases as follows -

A) Calculation of depricialtion by SL method -

Dep= 3500000-500000/4 = 750,000 per year.

We calculate the sensitivity in NPV as per the following-

Sensitivity NPV= (# Change in NPV btw New and Baseline Scenario) / Baseline NPV

For the following 4 years the project is analysed as follows -

Baseline NPV for the basic initial scenario is as follows -

Yr 0 = Cash outflows -3500000 & -850000 for investments in P&M and WC

Yr 1= 2185000 (Positive Cash flow)

Yr 2= 2185000 (Positive Cash flow)

Yr 3= 2185000 (Positive Cash flow)

Yr 4= 2185000 +500000salvage+850000 Wc recovery (Positive Cash flow)

Discounting all the cash flows with the discount rate of 10% we get

BaseLine NPV= 3498224

Now

Worst Case Scenario

The worst case sceario parameters are now applied to analyze the changes in NPV,

Cash flows are as follows -

Yr 0 = Cash outflows -3500000 & -850000 for investments in P&M and WC

Yr 1= -2006000

Yr 2= -2006000

Yr 3= -2006000

Yr 4= -2006000+500000salvage+850000 Wc recovery (Positive Cash flow)

Discounting we get NPV as

NPV Worst = -9786681

Sensitivity = -9786681 -baseline npv / Baseline NPV = -3.797 times

Best Case

We have the following

Yr 0 = Cash outflows -3500000 & -850000 for investments in P&M and WC

Yr 1= 6968800

Yr 2= 6968800

Yr 3= 6968800

Yr 4= 6968800+500000salvage+850000 Wc recovery (Positive Cash flow)

Discounting we get

Best Case NPV = 18662226

NPV Sensitivity = 18662226-Baseline NPV/ 3498224 = 4.33 times .