Problem #5 Sensitivity and Scenario Analyses

Consider the following "base case" capital Project:

Unit Price $6.50

Annual unit sales 52,000

Variable cost per unit $1.75

Investment in fixed capital $350,000

Investment in working capital $60,000

Project life 7 years

Depreciation (straight line) $50,000

Expected salvage value $45,000

Tax rate 35 percent

Required rate of return 11 percent

(a) Calculate the incremental operating cash flows.

Cash Flows = __________________________

(b) Calculate the terminal year after-tax non-operating cash flow.

TNOCF = __________________________

(c) Calculate the NPV.

Net Present Value (NPV) = __________________________

Internal rate of return (IRR) = __________________

(d) We will now perform a sensitivity analysis by recalculating the NPV by changing the value of one variable at a time. Consider the following base, low and high values for each of the input variables listed below.

Base value Low value High value

Unit price $6.50 $6.00 $7.00

Annual unit sales 52,000 50,000 55,000

Variable cost per unit $1.75 $1.50 $2.00

Expected salvage value $45,000 $30,000 $60,000

Tax rate 35 percent 30 percent 40 percent

Required rate of return 11 percent 10 percent 13 percent

Fill out the table below by recalculating the NPV under each individual change.

Project NPV

With low estimate With high estimate Range of estimates

Variable ___________ ______________ ______________

Unit price ___________ ______________ _____________

Annual unit sales ___________ _____________ ______________

Variable cost per unit ___________ _____________ ______________

Expected salvage value ___________ ____________ _____________

Tax rate ___________ _____________ _____________

Required rate of return ___________ _____________ ______________

(e) Which of the variables has the most effect on NPV? How do you explain it?

(f) Consider the following three scenarios:

SCENARIO

Variable Pessimistic Most likely Optimistic

Unit price $6.00 $6.50 $7.00

Annual unit sales 50,000 52,000 55,000

Variable cost per unit $2.00 $1.75 $1.50

Investment in fixed capital $385,000 $350,000 $315,000

Investment in working capital $80,000 $60,000 $40,0000

Project life 7 years 7 years 7 years

Depreciation (straight line) $55,000 $50,000 $45,000

Salvage value $30,000 $45,000 $60,000

Tax rate 40 percent 35 percent 30 percent

Required rate of return 13 percent 11 percent 10 percent

Based on these values above, calculate the NPV under these three scenarios. Fill out table below.

Pessimistic Most likely Optimistic

NPV = _______ ______ ______