Question

Please solve parts f through j.
We are considering the introduction of a new product. Currently we are in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the new project: Cost of new plant and equipment: Shipping and installation costs: Sales price per unit: Variable cost per unit: Annual fixed costs: $7,900,000 $100,000 $300/unit in years 1 through 4, $260/unit in year 5 $180/unit $200,000 per year in years 1-5 Working-capital requirements: There will be an initial working-capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5. Use the simplified straight-line method over 5 years. Assume that the plant and equipment will have no salvage value after 5 years. Year 1 2 3 Units Sold 70,000 120,000 140,000 80,000 60,000 4 5

Answer 1

Computation of net cash inflow per year

YEAR 1 - Units sold = 70000

	Particulars	Amount ($)
A	Selling Price per Unit	300
B	Variable Cost per unit	180
C	Contribution per unit	120
D	Number of units sold	70000
E	Total Contribution	8400000
F	Fixed Cost	200000
G	Net Cash Inflow ( Year 1)	8200000

YEAR 2 - Units Sold 120000

	Particulars	Amount ($)
A	Selling Price per Unit	300
B	Variable Cost per unit	180
C	Contribution per unit	120
D	Number of units sold	120000
E	Total Contribution	14400000
F	Fixed Cost	200000
G	Net Cash Inflow ( Year 2)	14200000

YEAR 3 - Units Sold 140000

	Particulars	Amount ($)
A	Selling Price per Unit	300
B	Variable Cost per unit	180
C	Contribution per unit	120
D	Number of units sold	140000
E	Total Contribution	16800000
F	Fixed Cost	200000
G	Net Cash Inflow ( Year 3)	16600000

YEAR 4 - Units Sold - 80000

	Particulars	Amount ($)
A	Selling Price per Unit	300
B	Variable Cost per unit	180
C	Contribution per unit	120
D	Number of units sold	80000
E	Total Contribution	9600000
F	Fixed Cost	200000
G	Net Cash Inflow ( Year 4)	9200000

YEAR 5 - Units Sold 60000

	Particulars	Amount ($)
A	Selling Price per Unit	260
B	Variable Cost per unit	180
C	Contribution per unit	80
D	Number of units sold	60000
E	Total Contribution	4800000
F	Fixed Cost	200000
G	Net Cash Inflow ( Year 5)	4600000

Compuation of Initial Cash Outflow:

Cost of the new plant and equipment = $ 7900000

Shipping and installation costs = $ 100000

Working Capital Requirement = $ 100000

Total Cash Outflow = $ 8100000

Computation of Annual Depreciation

annual Depreciation = Cost of the Asset / 5 = $7900000/5 = $ 15800000

Computation of Incremental Cash Flows

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Profit	8200000	14200000	16600000	9200000	4600000
Less: depreciation	15800000	15800000	15800000	15800000	15800000
Profit/loss before tax	(7600000)	(1600000)	800000	(6600000)	(11200000)
Less : Tax@ 34%	-	-	272000	-	-
Profit/loss after tax	(7600000	(1600000)	528000	(6600000)	( 11200000)
Add : Depreciation	15800000	15800000	15800000	15800000	15800000
Project Earnings	8200000	14200000	16328000	9200000	4600000

Less: Working capital requirement 2100000 3600000 4200000 2400000 -

Annual Cash Inflows 6100000 10600000 12128000 6800000 4600000

Statement showing computation of Net present values

YEAR	PVF @ 15 %	Cash flows	Discounted Value
1	0.8696	6100000	5304560
2	0.7561	10600000	8014660
3	0.6575	12128000	7974160
4	0.5717	6800000	3887560
5	0.4971	4600000	2286660
		TOTAL	27467600

NET PRESENT VALUE = SUM OF DISCOUNTED CASH INFLOWS - CASH OUTFLOW

= $ 27467600 - $ 8100000

= $ 19367600

Computation of INTERTNAL RATE OF RETURN

Average Cash Inflow = ($6100000 + $10600000 + $12128000 + $ 6800000 + $ 4600000) /5

= $40228000/5

= $8045600

Present Value of Annuity ( Expected ) = initial Cash Outflow/ Average Cash Inflow

=$8100000/ $8045600

= 1

Techniques for risk analysis in capital budgeting:

1. Probability

2. Variance or Standard Deviation

3. Coefficient of Variation

Steps for Simulation Analysis:

1. Identification of variables that influence cash inflows and outflows.

2. Specify values of parameters and probability distributions of variables.

3. Select a value at random from probability distribution of each of the variables.

4. Determine NPV corresponding to the randomly generated value of variables.

5. Repeat steps (3) & (4) a large number of times to get a large number of simulated NPVs.

6. Plot probability distribution of NPVs

SENSITIVITY ANALYSIS AND ITS PURPOSE

As per CIMA terminology,” A modeling and risk assessment procedure in which changes are made to significant variables in order to determine the effect of these changes on the planned outcome. Particular attention is thereafter paid to variables identifies as being of special significance”

Sensitivity analysis put in simple terms is a modeling technique which is used in Capital Budgeting decisions which is used to study the impact of changes in the variables on the outcome of the project. In a Project, several variables like Weighted average cost of capital, consumer demand, price of the product, cost price per unit etc. operate simultaneously. The changes in these variables impact the outcome of the project. It therefore becomes very difficult to assess change in which variable impacts the project outcome in a significant way. In Sensitivity Analysis, the project outcome is studied after taking into change in only one variable. The more sensitive is the NPV, the more critical is that variable. So, Sensitivity analysis is a way of finding impact in the project’s NPV (or IRR) for a given change in one of the variables.