You've been offered a full time position as an assistant financial analyst at Bathurst Metal Works. 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 project in question but also 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: Assistant Financial Analyst
From: Chief Financial Officer
Re: Capital budgeting and risk analysis
You are required to conduct a risk analysis of the following new project, as outlined below. This new project involves purchase of a new laser cutting tool that can be used in Bathurst Metal Works' manufacturing division. The products manufactured using the new technology are expected to sell for an average price of $300 per unit, and the company analyst performing the analysis expects Bathurst Metal Works can sell 20,000 units per year at this price for a period of five years. To get started 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, Bathurst Metal Works 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 as follows:
Initial cost of the equipment $2,000,000
Project and equipment life 5 years
Salvage value of equipment $200,000
Working capital required $300,000
Depreciation method Straight line
Depreciation expenses $360,000
Discount rate or required rate of return 12%
Tax rate 30%
In addition, estimates for unit sales, selling price, variable cost per unit and cash fixed cost for the base- case, worst-case and best-case scenario are as follows:
Base-case Worst-case Best-case
Unit Sales 20,000 15,000 25,000
Price per unit $300 $250 $330
Variable cost per unit $200 $210 $180
Cash fixed cost per year $500,000 $450,000 $350,000
Depreciation $360,000 $360,000 $360,000
i. Estimate the cash flows for the investment under the listed base-case value assumptions. Calculate the project's NPV for these cash flows.
ii. Evaluate the NPV of the investment under the worst-case assumptions.
iii. Evaluate the NPV of the investment under the best-case assumptions.
iv. Explain how sensitivity and scenario analysis are useful for evaluating project risk?
v. How can break-even analysis be helpful in evaluating project risk?