FINC3015 Lecture Notes - Lecture 6: Sensitivity Analysis, Earnings Before Interest And Taxes, Scenario Analysis

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30 Jul 2018

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Determining the value of an investment project is relatively straightforward when future cash flows are known. The expected cash flows in our valuation analysis are cash flows under the most likely scenario. These should equal to a probability-weighted average of cash flows under all possible scenarios. However, there are some scenarios where the cash flows will be different from expectations (higher or lower). In project risk analysis, we estimate expected cash flows and asset value under various scenarios with the intent of getting a better sense of the effect of risk on value. To assess the impact of uncertainty on project outcomes, we mainly focus on three tools: scenario analysis, breakeven sensitivity analysis, simulation analysis. These tools provide analysts with further information that they can use to determine the key factors driving the success (failure) of a particular project. In conducting sensitivity analysis: understand consequences of misestimating key project variables.

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PLEASE ONLY ANSWER QUESTION 1.6 - 1.11

Merafe Mining is evaluating the possibility of adding a new product line to its product mix. Because the exercise requires a detailed analysis of all possible risk scenarios or cases, EY was contracted to perform capital budgeting analysis for Merafe. The new machinery would cost Merafe an estimated amount of R200 000. A further R10 000 would be required for shipping charges and additional amount of R30 000 is estimated for installation of the new equipment.
Assume an economic life of 4 year for the machinery and the depreciation is based on MACRS 3-year class. Assume the following MACRS 3-year class depreciate rates:

year 1: 33.33%,

year 2: 44.45%,

year 3: 14.81%,

year 4: 7.41%.
The machinery is expected to have a salvage value of R25 000 after 4 years of use.
The new product line would generate incremental sales of 1 250 units per year for 4 years at an incremental cost of R100 per unit in the first year, excluding depreciation. Each unit can be sold for R200 in the first year. The sales price and cost are both expected to increase by 3% per year. Further, to handle the new line, the companyâs net working capital would have to increase by an amount equal to 12% of sales revenues. Assume companyâs tax rate of 40%, and its overall weighted average cost of capital, which is the risk-adjusted cost of capital for an average project (r), is 10%.
1.2. What is Merafeâs depreciable basis? What are the annual depreciation expenses? (5)
1.3. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows? (5)
1.4. Construct annual incremental operating cash flow statements. (5)
1.5. Estimate the required net working capital for each year, and the cash flow due to investments in net working capital. (3)
1.6. Calculate the after-tax salvage cash flow. (3)
1.7. Calculate the net cash flows for each year. Based on these cash flows and the average project cost of capital, what are the projectâs NPV, IRR, PI, payback, and discounted payback? Do these indicators suggest that the project should be undertaken? (10)
1.8. Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the project. Assume each of these variables can vary from its base-case, or expected, value by +-10%, +-20%, and +-30%. Discuss the results. (8)
1.9. Assume that EY is confident of its estimates of all the variables that affect the projectâs cash flows except unit sales and sales price. If product acceptance is poor, unit sales would be only 900 units a year and the unit price would only be R160; a strong consumer response would produce sales of 1 600 units and a unit price of R240. EY believes that there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case).
Use the worst-, base-, and best-case NPVs and probabilities of occurrence to find the projectâs expected NPV, standard deviation, and coefficient of variation. (5)
1.10. Assume that Merafeâs average project has a coefficient of variation in the range of 0.2 to 0.4. Would the new line be classified as high risk, average risk, or low risk? What type of risk is being measured here? (3)
1.11. Merafe typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk. Should the new line be accepted? (3)

sangriahyena2

Given a project's expected cash flows, it is easy to calculate its NPV, IRR, MIRR, payback, and discounted payback. Cash flows are estimated based on information from various sources. There is uncertainty in a project's forecasted cash flows, and some projects are more uncertain and thus riskier than others. In this chapter, we illustrate how project cash flows are estimated, discuss techniques for measuring risk, and discuss how to choose between projects that have significantly different lives, are mutually exclusive, and can be repeated.

The most critical step in capital budgeting analysis is cash flow estimation.

The key is to focus on only

a. relevant

b. net income

c. incremental accounting income or

d. incremental cash flows.

Factors that complicate the analysis are sunk costs, opportunity costs, externalities, changes in net operating working capital, and salvage values. Adjustments to the analysis must be made for

a. inflation

b. interest

c. dividends

We concentrate on expansion project analyses here but there are similarities when analyzing replacement projects.

Give the correct response to each of the following questions.

Which of the following items should be included in the capital budgeting analysis?
a. Sunk costs

b. Interest payments

c. Dividend payments

d. Opportunity costs

An outlay that was incurred in the past and cannot be recovered in the future regardless of whether the project under consideration is accepted is known as
a. Opportunity cost

b. Externality

c. Sunk cost

d. Cannibalization

Which of the following is an example of an opportunity cost?
a. A publisher introduces a new textbook which reduces sales of one of their existing textbooks.
b. A firm has land that can be used in building a new store. If the new store is not built, the firm could sell the land for $2 million (net of taxes).
c. Apple's investment in the iTunes music store boosted sales of its iPod.
d. The cost of a report done 2 years ago to investigate the potential of a new plant and the permits required to build it.
e. Statements a and d are both examples of opportunity costs.
The correct response is -Select-statement astatement bstatement cstatement dstatement eItem 6 .

Which of the following is an example of cannibalization?
a. A publisher introduces a new textbook which reduces sales of one of their existing textbooks.
b. A firm has land that can be used in building a new store. If the new store is not built, the firm could sell the land for $2 million (net of taxes).
c. Apple's investment in the iTunes music store boosted sales of its iPod.
d. The cost of a report done 2 years ago to investigate the potential of a new plant and the permits required to build it.
e. Statements c and d are both examples of cannibalization.
The correct response is -Select-statement astatement bstatement cstatement dstatement eItem 7 .

I just need part E the rest has been answered

Mississippi Delta, Inc. has been selling switching equipment to computer companies on net-30 terms, in which payment is expected by 30 days from the invoice date. Concerned about deteriorating collection patterns, the credit manager has divided customers into two groups for examination purposes: Prompt payors and laggards. Prompt payors (80 percent of Mississippi Deltaâs customers) pay, on average, in 35 days, versus a 72-day average for the laggards. The manager wonders if the credit terms should be modified to include a 2 percent cash discount on invoices paid within 10 days. The average invoice is the same for both groups, roughly $4,000. The manager expects 50% of the prompt payors to pay in exactly 10 days and the average on the other half to slip to 40 days. He thinks that 20% of the laggards will pay in 10 days and the average on the others will slip to 80 days. Given these forecasts, he is not sure that the lost revenue from discount takes (who would then pay only 98% of the invoiced dollar amount) justifies the improved collection. The companyâs annual cost of capital is 11%. A.) Using NPV calculations, show the PV of the present collection experience. B.) Calculate the NPV of the proposed 2/10, net-30 terms. C.) Based on your NPV analysis, should Mississipi Delta Inc. adopt the cash discount? D.) What other factors should be taken into account before Mississippi Delta Inc. makes a switch, assuming such is justifiable on an NPV basis? E.) Sensivity analysis involves varying the key assumptions, one at a time, and observing the effect on the key decision criterion-such as profits or NPV. In the NPV analysis above, how could could one carry out sensitivity analysis? (If you have a financial spreadsheet available, conduct a sensitivity analysis that varies the number of prompt payors who will pay in exactly 10 days and report your findings.) *** Answer in an Excel document and give explanation as to how and why you got to your answer View comments (1) Expert Answer snarulatutor snarulatutor answered this 48 minutes later Was this answer helpful? 1 0 1,896 answers Since, there are multiple questions, the first four have been answered. ___________ Part A) To calculate the NPV, we need to determine the values of cash flows. Cash Flow on the 35th Day = Invoice Value*Customer Percentage Making the Payment on 35th Day = 4,000*80% = 3,200 Cash Flow on the 72th Day = Invoice Value*Customer Percentage Making the Payment on 72th Day = 4,000*20% = 800 The net present value of these 2 cash flows can be calculated as follows: Net Present Value = 3,200/(1+11%/365)^35 + 800/(1+11%/365)^72 = $3,949.26 ___________ Part B) To calculate the NPV, we need to determine the values of cash flows. Cash Flow on 10th Day = Invoice Value*Customer Percentage Taking Discount*(1-Discount Percentage) = 4,000*80%*50%*(1-2%) + 4,000*20%*20%*(1-2%) = $1,724.80 Cash Flow on 40th Day = Invoice Value*Customer Percentage Making Payment on 40th Day = 4,000*40% = $1,600 Cash Flow on 70th Day = Invoice Value*Customer Percentage Making Payment on 40th Day = 4,000*20%*80% = $640 The net present value of these 3 cash flows can be calculated as follows: Net Present Value = 1,724.80/(1+11%/365)^10 + 1,600/(1+11%/365)^40 + 640/(1+11%/365)^70 = $3,927.08 ___________ Part C) The net present value of cash flows with discount ($3,927.08) is less than the net present value of cash flows without discount ($3,949.26). Therefore, the company should not adopt the cash discount. ___________ Part D) Some of the other factors that should be taken into consideration include the possibility of default risk (as the credit period in case of laggards has increased to 80 resulting in higher probability of default). Another factor to be considered is the payment terms available from the suppliers. The company can adopt a cash discount policy, if it is also getting a discount on early payments to its suppliers. Credit policies used within the industry or by other companies of the same nature and size can be used as reference points while devising a credit policy.

I just need part E) and it explained

FINC3015 Lecture Notes - Lecture 6: Sensitivity Analysis, Earnings Before Interest And Taxes, Scenario Analysis

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