Question 1: Annual sales revenue and costs (other than depreciation)
Year 1 | Year 2 | Year 3 | Year 4 | |
Units | 1350 | 1350 | 1350 | 1350 |
Unit price | $200 | $206 | $212.18 | $218.55 |
Unit cost | $100 | $103 | $106.09 | $109.27 |
Sales | $270000 | $278100 | $286443 | $295036.3 |
Cost | $135000 | $139050 | $143221.5 | $147518.1 |
The market interest rate, which is the cost of capital, has a premium for inflation. Without the premium for inflation, the real interest rate will be less than the nominal interest rate. This will result to a nominal cash flow, which is greater than real cash flow since nominal cash flow incorporates inflation. If the real cash flow is discounted at the nominal interest rate, the result will be a low net present value. Thus, real cash flow is discounted at the real interest rate and nominal cash flow discounted with the nominal interest rate. It is much more realistic to calculate the nominal cash flow than to reduce the nominal interest rate to real interest rate.
Question 2: Annual incremental operating cash flow statements
Year 1 | Year 2 | Year 3 | Year 4 | |
Units | 1,350 | 1,350 | 1,350 | 1,350 |
Unit price | $200.00 | $206.00 | $212.18 | $218.55 |
Unit cost | $100.00 | $103.00 | $106.09 | $109.27 |
Sales | $270,000 | $278,100 | $286,443 | $295,036 |
Costs | 135,000 | 139,050 | 143,222 | 147,518 |
Depreciation | 99,990 | 133,350 | 44,430 | 22,230 |
Operating income before taxes (EBIT) | $35,010 | $5,700 | $98,792 | $125,288 |
Taxes (40%) | 14,004 | 2,280 | 39,517 | 50,115 |
EBIT (1 – T) | $21,006 | $3,420 | $59,275 | $75,173 |
Depreciation | 99,990 | 133,350 | 44,430 | 22,230 |
Net operating CF | $120,996 | $136,770 | $103,705 | $97,403 |
Annual Cash Flows due to Investments in Net Working Capital
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | |
Sales | $270,000 | $278,100 | $286,443 | $295,036 | |
NWC ( 40% of sales) | 40,500 | 41,715 | 42,966 | 44,255 | |
CF due to investment in NWC) | (40,500) | (1,215) | (1,251) | (1,289) | 44,255 |
After-tax salvage cash flow
Salvage value | $25,000 |
Book value | 0 |
Gain or loss | $25,000 |
Tax on salvage value (@ 40%) | 10,000 |
Net terminal cash flow | $15,000 |
Question 3: projected Net cash flows
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | ||
Long Term Assets | ($300,000) | 0 | 0 | 0 | 0 | |
Operating Cash Flows | 0 | $120,996 | $136,770 | $103,705 | $97,403 | |
CF due to investment in NWC | (40,500) | (1,215) | (1,251) | (1,289) | 44,255 | |
Salvage Cash Flows | 0 | 0 | 0 | 0 | 15,000 | |
Net Cash Flows | ($340,500) | $119,781 | $135,519 | $102,416 | $156,658 |
NPV = ∑ {Net Period Cash Flow/ (1+R)^T} – Initial Investment
= ($119,781/(1+0.12)^{1 })+($135,519/(1+0.12)^{2 })+($102416/(1+0.12)^{3})+($156,658/(1+0.12)^{4})-$340,500
= $46,939
IRR
This is the interest rate at which the net present value is zero. It is calculated from the NPV formula by solving for R when the NPV is zero.
IRR = 18.2%.
MIRR = (FVCF(c) / PVCF (fc)) ^ ^{(1 / n) -1}
= 15.7 %
Payback Period
Years | 0 | 1 | 2 | 3 | 4 | |
Cash Flow | ($340,500) | $119,781 | $135,519 | $102,416 | $156,658 | |
Cumulative Cash Flow for Payback | ($340,500) | ($220,719) | ($85,200) | $17,216 | $173,874 |
Payback Period= 2.8 Years
The net present value rule indicates that a project is undertaken if the NPV is positive. In this case, the NPV is positive. The IRR rule on the other hand considers the value of IRR and the WAC. If IRR exceeds the WAC, then the project should be undertaken. IRR in this scenario is 18.2% and WAC is 12%. Thus, the IRR exceeds WAC and the project is fit to be undertaken. The MIRR rule is similar to that of IRR. Since MIRR is greater than cost of capital, the project is accepted. The payback period is less than the economic life of the machinery. The project will have paid back in 2.8yers while the economic life of the machine is 4 years. This indicates that the project is profitable and thus acceptable. All the rules of capital budgeting indicates that this project should be accepted.
Question 4: Risk
In the context of capital budgeting, risk is the possibility of an investments actual returns being lower than the expected return. Risk involves losing some of the investment or the whole investment. The risk of a specific investment is measured by determining the standard deviation of the investments or the average returns of the historical returns. A high standard deviation is a sign of a high degree of risk.isk is quantified by attaching some probabilities I the happenings of negative events. If it is certain that, an event cannot occur, it is assigned a probability of zero and if certain it will occur, it is given a probability of one. The above two are assigned when the risk is certain. When the risk is uncertain, the probability assigned is between zero and one. Maximum risk occurs when there is maximum uncertainty at probability of 0.5.
Some types of project, historical data is very significant in assessing risk. The use of historical data is common when the investment involves an expansion. A company looking to expand can use its historical data to assess the risk involved. For a new business, a company can look at the historical data of other companies in the same line of business and assess risk. In some instances, historical data may not be available. In such a case, a company will have to depend on the judgment of the executives. In addition, some of the statistics used in analyzing historical data are based on subjective judgment. The availability of data determines the method used to quantify risk.
Question 5: Sensitivity Analysis
Sensitivity analysis is a technique used to determine how different values of an independent variable impact on a dependent variable under some given assumptions. It is a way of predicting the outcome of a decision made given a range of variables. It shows how change in one variable affects the outcome. The technique is incorporated in capital budgeting to unearth the possible relationships between a project and profitability, sales, liquidity and the overall capital management of the entity.
Among the major weaknesses of sensitivity, analysis is that it is irrelative in nature. It only considers the extent of a change and not the probability of that change occurring. In addition, in standalone form, it offers no solution. The information it provides requires further analysis and interpretation to reach to a decision. It also assumes that variables can change independent of other variables.
Sensitivity analysis is very simple and is a source of information to direct the managements planning efforts. Through its application, information is made available to the management in a form that guides professional decision-making. In addition, it identifies areas where the management needs to concentrate in to attain the overall goal of the organization. The technique is also used to check for quality. When the management know which variables are crucial in the success of a project, then they can b able to intensify the success of the project.
Deviation | NPV Deviation from Base Case | ||
from | Units | ||
Base Case | WACC (r) | Sold | Salvage |
-30% | $173,928 | $14,687 | $125,079 |
-15% | 159,237 | 59,392 | 126,509 |
0% | 145,337 | 104,096 | 127,939 |
15% | 132,172 | 148,801 | 129,369 |
30% | 119,693 | 193,505 | 130,799 |
Range | $54,235 | $208,193 | $5,720 |
A steep sensitivity line shows a greater risk. Along the line, a small change in any variables results to a decline in the net present value. From the graph above, the units sold line is steep than the interest rate and salvage value lines. This shows that a small change in estimated sales leads to a large decline in the net present value. This shows that Sydney Johnson needs to worry more about the accuracy in estimating and forecasting sales.
Question 6:
Scenario | Probability | Unit Sales | Unit Price | NPV | |
Best Case | 25% | 2,000 | $220 | $278,940 | |
Base Case | 50% | 1,350 | $200 | $88,010 | |
Worst Case | 25% | 1,000 | $150 | ($48,527) | |
Expected NPV = $ 101,608
σ = $116,573 CV = σ/Expected NPV = 1.15 |
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Question 7: Scenario Analysis
This is a technique for estimating the expected returns of a project after a specific period. It assumes that specific changes in the key project factors take place. Commonly, it is used to estimate the changes to the value of an investment after unfavorable conditions. The analysis involves determining expected returns different reinvestment rates. Using mathematical and statistical principles, scenario analysis provides a basis to estimate the changes in value of an investment after the occurrence of a different situation rather than the expected situation. Scenario analysis usually considers three outcomes, which are best case, most likely case and worst case.
Scenario analysis is significant in that it presents the stakeholders and interested parties with an avenue to discuss critical questions. It also offers a shift from what is certain to what could happen. It makes it possible to determine the foreseeable outcomes an explore them. In addition, it encourages creativity. When defining scenarios, it encourages thinking about possibilities instead of what can happen. This kind of thinking can generate creative ideas and solutions to issues that arise in the future. However, it can oversimplify an issue given that the analysis has to balance with the time and resources available. Again, scenario analysis just generated ideas which need to be put in to practice.
Question 8: Simulation Analysis
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