Question

Question 1. Cashion International (Sensitivity Analysis)
Cashion International are considering a project that is susceptible to risk. An initial investment of £90,000 will be followed by three years each with the following most likely cash flows The initial investment consists of £70,000 in machines, which have a zero scrap value at the end of the three year life of the project and £20,000 in additional working capital which is recoverable at the end. The discount rate is 10%.


Sales (100,000 units) £200,000
Labour costs £100,000
Material costs £40,000
Other costs £10,000 £150,000
Net cash flow    £ 50,000

Required:
For the four variables of
i. Sales price
ii. Labour costs
iii. Material costs
iv. Discount rate
a) Rank the above in terms of their sensitivity to the project outcome and calculate the percentage deviation before breakeven NPV is reached
b) Discuss how the management of Cashion would use this information.

Answer 1

Part a:

Ranking on the basis of sensitivity is provided below.

Sensitivity rank:	Rank
Sales price	I
Labour cost	II
Material costs	III
Discount rate	IV

Workings:

Present value factors @ 10%	0.909090909	0.82644628
Particulars	Amount (£)	Amount (£)
Present value of total cash inflow	1,24,342.60
Add: Present value of working capital to be recovered	15,026.30
Present value of cash flows	1,39,368.90
Less: Initial investment	90,000.00
Net present value	49,368.90
Sensitivity levels
Sales price
Current sales price (200000/100000)	2
If sales price is decreased by 10%
New sales price	1.8
NPV will be
Net annual cash flow	30000
Particulars	Amount (£)	Amount (£)
Present value of total cash inflow	74,605.56
Add: Present value of working capital to be recovered	15,026.30
Present value of cash flows	89,631.86
Less: Initial investment	90,000.00
Net present value	-368.14
Change in sales price	10%
Sensitivity (%)	-100.745701
Sensitivity of sales price is	-100.75
Labour cost
Current labour cost	100000
Increase of 10%
New labour cost	110000
Net annual cash flow	40000
Present value factors @ 10%	0.909090909	0.82644628
Particulars	Amount (£)	Amount (£)
Present value of total cash inflow	99,474.08
Add: Present value of working capital to be recovered	15,026.30
Present value of cash flows	1,14,500.38
Less: Initial investment	90,000.00
Net present value	24,500.38
Change in labour cost	10%
Change in NPV	-50.37
Material cost
Increase of 10% in material cost
Current material cost	40000
New material costs	44000
Net annual cash flow	46000
Present value factors @ 10%	0.909090909	0.82644628
Particulars	Amount (£)	Amount (£)
Present value of total cash inflow	1,14,395.19
Add: Present value of working capital to be recovered	15,026.30
Present value of cash flows	1,29,421.49
Less: Initial investment	90,000.00
Net present value	39,421.49
Change in labour cost	10%
Change in NPV	-20.15

Part b:

Management of Cashion would use this information to make important decisions such as pricing the products, salaries and wages policies of the employees and workers, purchasing raw materials and taking loan for investment or issuing capital for investment in new projects.