Sensitivity analysis The Kay Rona Cypress Company believes that by investing $10 million to modernize its manufacturing facilities, it can sell an additional 60,000 units of its product in each of the next five years. The company believes it can charge customers $240 per unit, and it expects to achieve a gross profit margin of 30%. The forecast calls for operating expenses equal to 10% of sales, and the tax rate is 21%. Kay Rona has a cost of capital of 10%.

a. Suppose the $10 million investment will be depreciated on a straight-line basis for five years. Assume after five years the used equipment will have no market value. What is the project’s NPV?

b. Now suppose that the investment is eligible for 100% bonus depreciation in the first year. Kay Rona is a profitable company, so any operating losses associated with this investment can be deducted against the company’s other income. What is the NPV now? Before you do the calculations, intuitively do you think the answer will be higher or lower than your answer in part a?

c. Return to the straight-line depreciation assumption from part a. Calculate the investment’s NPV at each of the following discount rates: 12%, 11%, 9%, 8%.

Draw an NPV profile using your answers here and in part a.

d. Again assuming straight-line depreciation and a 10% cost of capital, recalculate the project’s NPV for each value of the following key inputs. Each number represents either a 10% increase or decrease from the base-case assumptions.

Summarize what you learn from the sensitivity analysis of this project.

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Variable Volume Gross margin Op. expenses Product price Low 54,000 27% 9% $216 High 66,000 33% 11% $264