A small production company has estimated its sales, and sales price over the nex

Question

A small production company has estimated its sales, and sales price over the next five years as: 1 2 3 4 5

Sales 1000 1200 1400 1400 1400

Sales Price $100.00 $95.00 $92.00 $90.00 $89.00

Variable Costs $50.00 $52.00 $54.00 $55.00 $55.00 for each year.

Fixed costs are $20,000 up to 1250 units produced, and $25,000 above that.

There is an investment of $50,000 mainly for training and reorganizing some of the production layout. The company will be using existing equipment that has already been fully depreciated. The small company has a Tax Rate 29%. The owner, after reflecting his cost of capital, investment opportunities, and the risks of the project has decided that the Minimum Acceptable Rate of Return should be 15%

Being a new business, there is a high degree of uncertainty with the values that are compiled. The owner feels that there is a 20% chance that production/sales estimates might be as much as 10% too high, and 20% chance that they will be 10% too low.

There is also some uncertainty tied to the variable costs of the project. Based on the nature of the industry, he is quite sure of the values that he has estimated. Furthermore, it is very unlikely that these costs will be any lower. There is a 20% chance that the costs may increase by up to 8%.

His present estimates of the product price are based largely on expected increases in the competition that this industry will experience, and the pressures that will be imposed on the price as the supply of goods starts meeting demand. Depending on how much demand may increase in the market, and the extent to which supply is increased, conditions of over, or under supply may be established. The owner estimates that there is a 20% chance that a condition of oversupply will be generated in which case sales prices in years 3, 4, and 5 will decrease by 4%, 6%, and 8% respectively. Similarly, there is a 20% chance that a condition of undersupply may exist in which case the sales price will most likely increase by 4%, 6%, and 8% in years 3, 4, and 5 respectively.

How to set the data provided for a risk analysis?

Explanation / Answer

In the given Project there is uncertainity of becoming sales and cost may be high or low (i.e. Most Likely Cost Pessimistic Cost Optimistic Cost Cm Cp Co In this scenario we use the expected cost or benefit formula to consider the risk     Here we using the Expected Cost formula as follows PERT Estimate formula is: Ce = (Co + 4Cm + Cp)/6 Where, Ce = Expected Cost Most Likely Cost Pessimistic Cost Optimistic Cost Cm Cp Co Case- 1 If all the are happended normally - Most Likely Event Year                                           1                                 2                                        3                              4                                      5 Sales Units                                  1,000                         1,200                               1,400                     1,400                             1,400 Selling Price Per Unit                                      100                               95                                     92                           90                                   89 Total Sales                              100,000                    114,000                           128,800                 126,000                         124,600 Less: Variable Cost             Per Unit                                        50                               52                                     54                           55                                   55 Total Variable Cost                                50,000                       62,400                             75,600                   77,000                           77,000 Contribution Margin                                50,000                       51,600                             53,200                   49,000                           47,600 Fixed Cost                                20,000                       20,000                             25,000                   25,000                           25,000 Net Income                                30,000                       31,600                             28,200                   24,000                           22,600 Less: Tax @ 29%                                  8,700                         9,164                               8,178                     6,960                             6,554 Profit after Tax                                21,300                       22,436                             20,022                   17,040                           16,046 PV Factor @ 15%                                0.8696                       0.7561                             0.6575                   0.5718                           0.4972 PV of Cash Inflow                                18,522                       16,965                             13,165                     9,743                             7,978 Total Cash Inflow                                66,372 Initial Cash Out flow                                50,000 NPV                                16,372 Case- 2 If all the are happended Very Good - Optimistic Scenario Year                                           1                                 2                                        3                              4                                      5 Sales Units                                  1,100                         1,320                               1,540                     1,540                             1,540 (Sales Increase by 10%) Selling Price Per Unit                                      100                               95                               95.68                     95.40                             96.12 Total Sales                              110,000                    125,400                           147,347                 146,916                         148,025 Less: Variable Cost             Per Unit                                  46.00                         47.84                               49.68                     50.60                             50.60 (Drease by 8 %) Total Variable Cost                                50,600                       63,149                             76,507                   77,924                           77,924 Contribution Margin                                59,400                       62,251                             70,840                   68,992                           70,101 Fixed Cost                                20,000                       25,000                             25,000                   25,000                           25,000 Net Income                                39,400                       37,251                             45,840                   43,992                           45,101 Less: Tax @ 29%                                11,426                       10,803                             13,294                   12,758                           13,079 Profit after Tax                                27,974                       26,448                             32,546                   31,234                           32,022 PV Factor @ 15%                                0.8696                       0.7561                             0.6575                   0.5718                           0.4972 PV of Cash Inflow                                24,325                       19,999                             21,400                   17,858                           15,920 Total Cash Inflow                                99,502 Initial Cash Out flow                                50,000 NPV                                49,502 Case- 3 If all the are happended Low - Pestimistic Scenario Year                                           1                                 2                                        3                              4                                      5 Sales Units                                      900                         1,080                               1,260                     1,260                             1,260 (Sales Decrease by 10%) Selling Price Per Unit                                      100                               95                               88.32                     84.60                             81.88 Total Sales                                90,000                    102,600                           111,283                 106,596                         103,169 Less: Variable Cost             Per Unit                                  54.00                         56.16                               58.32                     59.40                             59.40 (Increase by 8 %) Total Variable Cost                                48,600                       60,653                             73,483                   74,844                           74,844 Contribution Margin                                41,400                       41,947                             37,800                   31,752                           28,325 Fixed Cost                                20,000                       20,000                             25,000                   25,000                           25,000 Net Income                                21,400                       21,947                             12,800                     6,752                             3,325 Less: Tax @ 29%                                  6,206                         6,365                               3,712                     1,958                                 964 Profit after Tax                                15,194                       15,583                               9,088                     4,794                             2,361 PV Factor @ 15%                                0.8696                       0.7561                             0.6575                   0.5718                           0.4972 PV of Cash Inflow                                13,212                       11,783                               5,976                     2,741                             1,174 Total Cash Inflow                                34,885 Initial Cash Out flow                                50,000 NPV                              (15,115) PERT Estimate formula is: Ce = (Co + 4Cm + Cp)/6 Where, Ce = Expected Cost Expected Profit    =                                16,646 (49502+4*16372-15115)/6 Expected NPV is Positive so we can accpet the Project.

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