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

PROJECT A:	0	1	2	3	4	5
Annual revenues		$     3,50,000	$     3,50,000	$     3,50,000	$      3,50,000	$        3,50,000
-Variable costs		$        90,000	$         90,000	$         90,000	$         90,000	$           90,000
-Operating expenses		$        60,000	$         60,000	$         60,000	$         60,000	$           60,000
-Depreciation [500000/5]		$     1,00,000	$     1,00,000	$     1,00,000	$      1,00,000	$        1,00,000
=NOI		$     1,00,000	$     1,00,000	$     1,00,000	$      1,00,000	$        1,00,000
-Tax at 30%		$        30,000	$         30,000	$         30,000	$         30,000	$           30,000
=NOPAT		$        70,000	$         70,000	$         70,000	$         70,000	$           70,000
+Depreciation		$     1,00,000	$     1,00,000	$     1,00,000	$      1,00,000	$        1,00,000
=OCF		$     1,70,000	$     1,70,000	$     1,70,000	$      1,70,000	$        1,70,000
-Capital expenditure	$        5,00,000
-Change in NWC	$            50,000					$          -50,000
=FCF	$      -5,50,000	$     1,70,000	$     1,70,000	$     1,70,000	$      1,70,000	$        2,20,000
PVIF at 13%	1	0.88496	0.78315	0.69305	0.61332	0.54276
PV at 13%	$      -5,50,000	$     1,50,442	$     1,33,135	$     1,17,819	$      1,04,264	$        1,19,407
NPV	$            75,067
PROJECT B:	0	1	2	3	4	5	6
Annual revenues		$     2,50,000	$     2,50,000	$     2,50,000	$      2,50,000	$        2,50,000	$      2,50,000
-Variable costs		$        80,000	$         80,000	$         80,000	$         80,000	$           80,000	$          80,000
-Operating expenses		$        40,000	$         40,000	$         40,000	$         40,000	$           40,000	$          40,000
-Depreciation [300000/6]		$        50,000	$         50,000	$         50,000	$         50,000	$           50,000	$          50,000
=NOI		$        80,000	$         80,000	$         80,000	$         80,000	$           80,000	$          80,000
-Tax at 30%		$        24,000	$         24,000	$         24,000	$         24,000	$           24,000	$          24,000
=NOPAT		$        56,000	$         56,000	$         56,000	$         56,000	$           56,000	$          56,000
+Depreciation		$        50,000	$         50,000	$         50,000	$         50,000	$           50,000	$          50,000
=OCF		$     1,06,000	$     1,06,000	$     1,06,000	$      1,06,000	$        1,06,000	$      1,06,000
-Capital expenditure	$        3,00,000
-Change in NWC	$            30,000						$        -30,000
=FCF	$      -3,30,000	$     1,06,000	$     1,06,000	$     1,06,000	$      1,06,000	$        1,06,000	$      1,36,000
PVIF at 13%	1	0.88496	0.78315	0.69305	0.61332	0.54276	0.48032
PV at 13%	$      -3,30,000	$        93,805	$         83,014	$         73,463	$         65,012	$           57,533	$          65,323
NPV	$        1,08,150
RECOMMENDATION:
Project B is recommended as it has higher NPV.
SENSITIVITY:
Sensitivity measures the % change in NPV of a given % change in any of the variables. The variables may be revenues, costs, initial cost,
salvage value etc. It helps to understand the importance of each variable to the metric used [NPV] and helps to understand the risks
involed, when the variatio is unfavorable.
SCENARIO ANALYSIS:
Here, some of the variables, like revenues and costs are predicted for different economic scenarios with associated probabilities and
the expected value of NPV, the SD of NPV and the coefficient of variation etc are found out to assess the risks involved in the project.
SIMULATION:
Using statistical techniques a normal distribution for the cash flows are developed and the expected values, SD and coefficient of
variation are found out to assess the risk involved.