It \' s been four months since you took a position as an assistant financial ana

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It ' s been four months since you took a position as an assistant financial analyst at Caledonia Products. During that time, you've had a promotion and you are now working as a special assistant in capital budgeting, reporting directly to the CEO. Your latest assignment involves the analysis of several risky projects. Because this is your first assignment dealing with risk analysis, you have been asked not only to provide a recommendation on the projects in question, but also to respond to a number of questions aimed at judging your understanding of risk analysis and capital budgeting. The memorandum you received outlining your assignment follows: TO: The Special Assistant for Capital Budgeting From: Mr. V. Morrison, CEO, Caledonia Products RE: Capital Budgeting and Risk Analysis Provide a written response to the following questions: Explain how sensitivity analysis and scenario analysis are useful tools for evaluating project risk. What are real options? How does the presence of optionality in the investments that firms make case the traditionally calculated NPV of a projectt to be underestimated? Explain how simulation woks. What is the value of using a simulation approach? How can breakeven analysis be helpful in evaluating project risk? What is sensitivity analysis and what is its purpose? Now that they are comfortable with your skills. your boss would like you to look at a new project. This new project involves the purchase of a new plasma cutting tool that can be used in its metal works division. The products manufactured using the new technology are expected to sell for an average price of $303 per unit, and the company analyst performing the analysis expects the firm can sell 20,000 units per year at this price for a period of five years. To get into this business will require the purchase of a$2 million piece of equipment that has a residual or salvage value in five years of $200,000, in addition, the firm expects to have to invest an additional $300,000 in working capital to support the new business. Other pertinent information concerning the business venture is provided below: In addition, estimate for unit sales, selling price varaible cost per unit, and fixed operating expenses for the base-case, worst-case and best-case are describe below: Estimate the cash flows for the base-case a expected value assumptions listed above. Calculate the project NPV for these cash flows. Evaluate the NPV of the investment under the worst-case assumptions provided above. Evaluate the NPV of the investment under the best-case assumptions provided above.

Explanation / Answer

cash outflow cost of machine 2000000 working capital 300000 cash outflow 2300000 sales 20000 6000000 15000 3750000 25000 8250000 300 250 330 variable 200 4000000 210 3150000 180 4500000 contribution 2000000 600000 0 3750000 fixed cost 500000 450000 350000 depreciation 360000 360000 360000 ebit 1140000 -210000 3040000 tax 30% 342000 0 912000 cash flow after tax 798000 -210000 2128000 depreciation 360000 360000 360000 cash flow after tax before dep 1158000 150000 2488000 base case NPV worst case NPV Best case NPV year year year 1 1158000 0.892857 1033928.6 1 150000 0.892857143 133928.571 1 2488000 0.892857143 2221428.6 2 1158000 0.797194 923150.51 2 150000 0.797193878 119579.082 2 2488000 0.797193878 1983418.4 3 1158000 0.71178 824241.53 3 150000 0.711780248 106767.037 3 2488000 0.711780248 1770909.3 4 1158000 0.635518 735929.93 4 150000 0.635518078 95327.7118 4 2488000 0.635518078 1581169 5 1158000 0.567427 657080.3 5 150000 0.567426856 85114.0284 5 2488000 0.567426856 1411758 5 500000 0.567427 283713.43 5 500000 0.567426856 283713.428 5 500000 0.567426856 283713.43 sum of present value of cash flow 4458044.3 sum of present value of cash flow 824429.858 sum of present value of cash flow 9252396.6 cost of project 2300000 cost of project 2300000 cost of project 2300000 npv 2158044.3 npv -1475570.14 npv 6952396.6 1- sensitivity analysis is very useful it provide a detailed scenario under which how much npv can be earned and what are the rate of change in npv in different situations 2- A real option is an alternative or choice that becomes available with a business investment opportunity. Real options can include opportunities to expand and cease projects if certain conditions arise, amongst other options. They are referred to as "real" because they usually pertain to tangible assets such as capital equipment, rather than financial instruments. Taking into account real options can greatly affect the valuation of potential investments. Oftentimes, however, valuation methods, such as NPV, do not include the benefits that real options provide. 3- simulation is a kind of exercise which is generally performed to forecast the future. In simulation artificial financial conditions are created and scenarios are generated and then financial results are forecasted. 4- break even analysis may be useful in a way that atleast project should generate that much of cash flow so that financing and other costs are recovered. 5- sensitivity analysis define the rate of change in npv or cash flows when there is change in any scenario

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