Question

Again, your manager has tasked you with providing a recommendation regarding two alternative projects. You have identified the following two projects with the following characteristics:

                                                                        Project A                                Project B

CAPEX / Initial Outlay                                  $500,000                                 $300,000

Project life                                                       5 years                                     6 years

Revenue (per year)                                          $350,000                                 $250,000

Variable costs                                                 $90,000                                   $80,000

Operating expense                                          $60,000                                   $40,000

Investment in Net Working Capital (Year 0) $50,000                                   $30,000

The company’s tax rate is 30% and uses a straight-line depreciation method. There will be no ‘salvage’ value associated with these projects at the end of their project life. The company also anticipates it will recover all of the NWC at the end of the project. The company has a required rate of return of 13% per annum.

1. Determine the Free Cash Flows, for each year, to the firm for both projects.

2. Identify which project you recommend the company invest.   

3. Using your own words, briefly describe how to use the techniques of sensitivity, scenario and simulation analyses to estimate project risk?

Answer 1

a) The Free Cash flows (FCF) of the two projects are calculated as shown below

Free Cashflow Calculation of project A ($)
Year	0	1	2	3	4	5
Revenues		350000	350000	350000	350000	350000
Less :Variable cost		90000	90000	90000	90000	90000
Less: Operating Expense		60000	60000	60000	60000	60000
Less : Depreciation		100000	100000	100000	100000	100000
Profit before tax		100000	100000	100000	100000	100000
Less: Tax @30%		30000	30000	30000	30000	30000
Profit after tax		70000	70000	70000	70000	70000
Add Depreciation		100000	100000	100000	100000	100000
Cost of machine	500000	0	0	0	0	0
NWC	50000					50000
FCF	-550000	170000	170000	170000	170000	220000

Free Cashflow Calculation of project B ($)
Year	0	1	2	3	4	5	6
Revenues		250000	250000	250000	250000	250000	250000
Less :Variable cost		80000	80000	80000	80000	80000	80000
Less: Operating Expense		40000	40000	40000	40000	40000	40000
Less : Depreciation		50000	50000	50000	50000	50000	50000
Profit before tax		80000	80000	80000	80000	80000	80000
Less: Tax @30%		24000	24000	24000	24000	24000	24000
Profit after tax		56000	56000	56000	56000	56000	56000
Add Depreciation		50000	50000	50000	50000	50000	50000
Cost of machine	300000	0	0	0	0	0	0
NWC	30000						30000
FCF	-330000	106000	106000	106000	106000	106000	136000

b) NPV of project A =-550000+170000/0.13*(1-1/1.13^5)+50000/1.13^5 = $75067.31

NPV of project B =-330000+106000/0.13*(1-1/1.13^6)+30000/1.13^6 = $108149.83

Project B is better to invest as it has a higher NPV

c) The Sensitivity analysis analyses a project by changing one variable at a time and evaluating the effect of change of that variable on the Profit, NPV etc of the project. Helps in understanding Profit/NPV are more sensitive to which variable and less sensitive to which.

Scenario analysis shows various possible future scenarios and from the possible futures , it is possible to understand the risk and the probability of loss etc

Simulation assumes that variables have a certain probabilistic distribution and accordingly, the various possible cases (much more than that in scenario) are shown in simulation, From those simulations, it is possible to understand the probabilities of making loss, value at risk etc