Question

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 worst- and 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 sensitivity.

Answer 1

1) Sensitivity analysis to be under worst case and best case scenarios -

Before determining the worst and best case scenarios, below is the workings showing the NPV based on the ideal case scenario (given case scenario).

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
Units sold		650,000	650,000	650,000	650,000
Price per unit		$                         22	$                         22	$                         22	$                         22
Sales		$       14,300,000	$       14,300,000	$       14,300,000	$       14,300,000
Variable costs (@ 17 per unit)		$       11,050,000	$       11,050,000	$       11,050,000	$       11,050,000
Fixed costs		$             450,000	$             450,000	$             450,000	$             450,000
Depreciation^		$             750,000	$             750,000	$             750,000	$             750,000
Earnings Before Tax		$           2,050,000	$           2,050,000	$           2,050,000	$           2,050,000
Less: Tax @30%		$             615,000	$             615,000	$             615,000	$             615,000
Profit After Tax		$           1,435,000	$           1,435,000	$           1,435,000	$           1,435,000
Add: Depreciation		$             750,000	$             750,000	$             750,000	$             750,000
Cash Flow		$           2,185,000	$           2,185,000	$           2,185,000	$           2,185,000
Capital expenditure	$       -3,500,000				$ 3,500,000
Working Capital	$         -850,000				$ 850,000
Free cash flow	$       -4,350,000	$           2,185,000	$           2,185,000	$           2,185,000	$ 3,535,000
Discounting Factor @10%	1	0.9091	0.8264	0.7513	0.6830
Present Value	$       -4,350,000	$           1,986,364	$           1,805,785	$           1,641,623	$           2,414,453
NPV	$        3,498,224

^ Depreciation = (Purchase cost - Disposable value)/Life of the machine i.e. Dep = (3,500,000-500,000)/4 = $ 750,000.

a) Worst case scenarios.

Below table shows the NPV in each of the scenarios. These are calculated changing the relevant element in the base case scenario.

Sl. No	Scenario	NPV
i)	Unit sales decreases by 20%	$       2,055,935
ii)	Price per unit decreases by 20%	$     - 2,793,959
iii)	Variable cost increases by 20%	$ - 828,642
iv)	Fixed cost increases by $100,000 per year	$     - 3,110,945

b) Best Case scenario.

Below table shows the NPV in each of the scenarios. These are calculated changing the relevant element in the base case scenario.

Sl. No	Scenario	NPV
i)	Unit sales increases by 20%	$   4,940,513
ii)	Price per unit increases by 20%	$   9,267,379
iii)	Variable cost decreases by 20%	$   7,825,090
iv)	Fixed cost decreases by $100,000 per year	$   3,720,115

c) Based on the sensitivity draw the relevant conclusion. The project is highly sensitive to price per unit and Fixed cost and slightly sensitive to Variable cost. The project can withstand a fall in sales demand by more than 20% (upto 50% to breakeven).