RISK AND SENSITIVITY ANALYSIS After Muhammad submitted the cash flow calculations and the project profitability analysis results to Abdullah, they had the following conversation regarding the risk analysis for the project. Abdullah: The NPV, IRR, and discounted payback results are quite promising. However, we should also conduct a sensitivity analysis of the project before we go ahead with it. Since the new products are in-line with our nature of business, I do not believe the new project will change its beta and its overall market risk. Therefore, it should be sufficient to evaluate the stand-alone risk of the project. What are the techniques that we can use to assess the stand-alone risk of a project?

Muhammad: Sensitivity analysis is a widely used technique to determine how much a projects NPV will change in response to a given change in an input variable. Input variables such as sales or the cost of capital are often used while holding other things constant. Abdullah: Sales figures are difficult to forecast with a high degree of accuracy. Therefore, we should conduct a sensitivity analysis concerning possible changes in the forecasted sales figures. It should be sufficient to evaluate the impact of an increase or a decrease of 20% in sales from our base forecast. Our base sales forecast that the new expresso coffee maker will employ at about 70% capacity. Therefore, the unutilized capacity of the system should enable us to accommodate a 20% increase in sales. We can assume that the fixed coat will not change with the 20% increase or decrease in sales. Muhammad: No problem. We can conduct a sensitivity analysis for the projects NPV regarding a 20% deviation from our base sales forecast. We will use scenario analysis. In this technique, the best and worst-case NPV scenarios are compared with the projects expected NPV. Do you want us to conduct a scenario analysis of the project? Abdullah: Yes. It would be a good idea. As the best-case scenario, assume that the sales forecast will be 20% higher and for the worst-case scenario, assume that the sales forecast will be 20% lower. The expected return of the project is to remain at 200%. Muhammad: No problem. I should be able to submit the risk analysis results to you this afternoon. With the instructions he received from Abdullah, Muhammad immediately started to conduct the sensitivity analysis using scenario analysis techniques. QUESTION 5 Conduct the sensitivity analysis using scenario analysis techniques. (a) Prepare the statement of cash flow of operating activities and the net present value for the worst-case scenario (sales decrease by 20%), and

(b) Develop the statement of cash flow of operating activities and the net present value for the best-case scenario (sales increase by 20%).

(c) Based on your finding, what is your advice to the management?