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CHAPTER 11

2.

3. PROJECT RISK ANALYSIS

4.

5. A company has developed the following cash flow forecast for their new project.

6.

7.

Rs. in million

8.

Year 0

Years 1 10

9. Investment

(400)

10.

Sales

440

11.

Variable costs (75% of sales)

330

12. Fixed costs

20

13. Depreciation(Straight line method)

40

14. Pre-tax profit

50

15. Taxes( at 20 %)

10

16. Profit after taxes

40

17. Cash flow from operations

80

18. Net cash flow

80

19.

20. What is the NPV of the new project? Assume that the cost of capital is 10 percent.

The range of values that the underlying variables can take under three scenarios:

pessimistic, expected and optimistic are as shown below:

21.

22. Underlying Variable

Pessimistic

Expected

Optimistic

23. Investment

420

400

360

24. (Rs. in million)

25. Sales (Rs. in million)

350

440

500

26. Variable cost as a percent of sales

80

75

70

27. Fixed costs (Rs. in million)

25

20

18

28. Cost of capital (%)

11

10

9

29.

30.

(a) What are the NPVs under the different scenarios ?.

(b) Calculate the accounting break-even point and the financial break-even point for the

new project.

31.

Solution:

32.

33. (a)

34.

NPVs under alternative scenarios:

35.

(Rs. in million)

36.

Pessimistic

Expected

Optimistic

37.

38.

Investment

420

400

360

39.

Sales

350

440

500

40.

Variable costs

280

330

350

41.

Fixed costs

25

20

18

42.

Depreciation

42

40

36

43.

Pretax profit

3

50

96

44.

Tax @ 20%

0.6

10

19.2

2 sales – 8] x 6.145 =400 68. 85. Initial investment = 400 65. Price per unit 20 76. Net salvage value Nil 82. 64.2 sales – 8 61.25 x sales – 60] + 40 60.2 = 365. Contribution margin ratio = 110/440 = 0. Jawahar Industries has identified that the following factors. Quantity manufactured and sold annually 1. 49. 69. 89. Initial investment 10. Break even level of sales = 60 / 0. have a bearing on the NPV of their new project.145 63. 87. Life of the project 7 years 81. 48. Fixed costs 1. 83.240 million 57. Underlying variable Quantity manufactured and sold Price per unit Variable cost per unit Pessimistic 700 18 16 Optimistic 1. 52. 51. = [0. Annual net cash flow = 0. (b) Accounting break even point (under ‘expected’ scenario) 54. Fixed costs + depreciation = Rs. 72.158.400 23 14 . 60 million 55.6 363. 46. Tax rate 20 % 80.000 73.10) 62. 59.8 112.25 56.25 = Rs.000 75. PV (net cash flows) = [0. 50.95 Assumptions: (1) The useful life is assumed to be 10 years under all three scenarios. Financial break even point (under ‘expected’ scenario) 58.000 78. or Sales = ( 400/6. 70. 53.8 9% NPV .53 91.47 million.45. Cost of capital 11 % 74.2 sales – 8] x PVIFA (10%. 47. Assume that the following underlying variables can take the values as shown below: 84. Depreciation 1. Profit after tax Net cash flow Cost of capital 2.000 79.4 11 % 40 80 10 % 76.2 sales – 8] x 6.4 44. [0. 71. = 0. with their respective expected values.145 + 8) / 0. 66. 88.8[ 0. It is also assumed that the salvage value of the investment after ten years is zero. Variable cost per unit 15 77. 86. At the financial break even level of sales 67.

120.000 1.000 15.000 23.000 Profit after tax 1.712 Pessimistic Expected Optimistic Pessimistic Expected Optimistic 10. Expected Initial investment Sale revenue Variable costs Fixed costs Depreciation Profit before tax Tax Profit after tax Net cash flow NPV at PVIFA(11%. 107.021 17. = 4. 124.000 15.000 600 2. 116.000 Tax 300 600 1. and (c) variable cost per unit. 111. 103.800 5.7years) 105. 110.800 .000 10. 131.000 1. 119.000 1.000 21.200 3.518 6. (c) 128.560 Sensitivity of NPV with respect to variations in unit price.000 1. 114. 126. 106.1.(a) Calculate the sensitivity of net present value to variations in (a) quantity manufactured and sold. 115.000 1.000 1.000 20.400 10. 101.000 Sale revenue 14.000 6.000 1.000 Variable costs 10. 132.500 15.000 1.500 3.000 14. 122.200 4. 100.000 20.400 3. Initial investment Sale revenue Variable costs Pessimistic Expected Optimistic 10.400 5.712 366 6.7years) = 4.000 Fixed costs 1.000 20. 98.000 28. 96. 118. 129.000 5.000 1. 95. 127. 97.800 10. 102.000 16.000 15. 90.000 NPV at PVIFA(11%.000 10.021 13. 91. (b) price per unit. 112.400 4. 94.000 200 800 1.000 10.000 10. 104.000 1.000 18. (a) 92.000 20. 130. 113. 117.000 Depreciation 1. Sensitivity of NPV with respect to quantity manufactured and sold: Pessimistic 93.000 Net cash flow 2.000 15. 125.000 3. (b) 108. 133. 99. 123.330 Sensitivity of NPV with respect to variations in unit variable cost.000 1.000 .000 20.000 Profit before tax 1. 121. 109. Optimistic Initial investment 10.000 1.200 2.

3 + 4 x 0.712 1.69 173.9)2 x 0. 22 = [(2-2.4)2 x 0. 2 0.2 2 0.8)2 x 0. 179.2 + 3 x 0.000 800 3.7years) = 4. 136.9 / (1.200 4.2 + (3-1. 3.5 4 0. (1. A1 = 2 x 0.3 + 1 x 0. 148. 172.3 + (1-1. = + + = -----. Assume that the cash flows are independent.84 174.4 + 2 x 0. 135.2 + (4-2.+ ----177.5 million has the following benefits associated with it. 165.8 / 1.400 1.790 144.8)2 x 0.+ -----. 153. 12 22 32 0.12 + 2.41 million .12)3 – 5 169.84 176. = 2.2 + 4 x 0.12)2 (1.5 160. 168.3] = 0. A project involving an outlay of Rs.000 2. 139. Fixed costs Depreciation Profit before tax Tax Profit after tax Net cash flow NPV at PVIFA(11%. 1 0. 1 = [(2-1.3 + (4-2.400 3.021 9.12)2 (1. 155.9 164.200 2. 145. 162. (Rs. 137.3 4 0.76 0. Let At be the random variable denoting net cash flow in year t. 154.4 / (1.600 1. 159.69 1. A3 = 1 x 0. Cash Flow Prob. 143.12)2 + 2. = 2.12)6 (1.000 600 2.63 million 2 170.9)2 x 0. NPV = 1. in mln) (Rs. Year 1 Year 2 Year 3 147. 158.000 1.134.76 171. A2 = 2 x 0.3 2 0.4 167. 141.4 1 0.4 + 3 x 0. in mln) 149.000 4. 142.8)2 x 0.0.8 161.251 6. 138. 2 (NPV) 175.4)2 x 0.000 400 1.2 151.98 180.000 3. Cash Flow Prob.12)6 178. 32 = [(1-2.4 + (3-2. Calculate the expected net present value and the standard deviation of net present value assuming that i = 12 percent.5] = 0. in mln) (Rs. 146.3 163.4] = 1.4 152.000 1.000 1. = Rs.3 3 0.12)4 (1. (NPV) = Rs.4 166.4 150.4 + (2-2.1.4)2 x 0. Solution: 156. Cash Flow Prob.600 2. 157. 140.9)2 x 0. = 1.12)4 (1. 3 0. = 1.

191.000 197. The expected cash flows of a project are given below: 215.000 223. 4.000 Rs.840 + 10.000 x 0. 5. Year Cash Flow 217. 792] 203.000 / (1. 4 20.30. t=1 (1. if the risk-free interest rate is 6 percent.943 + 20.000 / (1. .30.000 x 0. =[ 18.943 + 4.000 219. = 16. 202.000.000 x 0. 2 30. Year Expected Value Standard Deviation 185.000 / (1. 209. 193.890 + 20.000/(1.06) + 20.000 190.000 / (1.785 213. 4 At 196.000/(1.000 / (1. .000 x 0. 4 10. 214.000 187. 5 10. Standard deviation of NPV 207. = .000 189.181.06)3 + 2.000 x 0. 192. 186.06)t 210.000 x 0.000 6. 0 (50. = 29. 2 20.06)2 + 6. 18.494 205.000 204.06)t 198. 211.000 222. + 10. = 18. 216.000 220.000 188.000 / (1.840 + 2.792 212. 206. 184. 182. The cash flows are perfectly correlated. Solution: 194.06)4 = 7.000 x0 .30.06) + 4.06)2 + 20. The expected value and standard deviation of cash flows are: 183. 1 10. 7. t=1 (1. 199.000 201.06)4 – 30.000) 218. 4 t 208. A project has a current outlay of Rs. Calculate the expected net present value and standard deviation of net present value of this investment.000 221. 3 20.000 4.000 x0 . 3 20. Expected NPV 195.06)3 200.000 2. = 7. 1 Rs.890 + 6.

08t . What is the net present value of the project under certainty equivalent method. if the risk-free rate of return is 8 percent and the certainty equivalent factor behaves as per the equation: t = 1 – 0.224.

NPV 241. 259. To introduce the product in the entire country right in the beginning would involve an outlay of Rs. -50000 12. 22. 3 29.2 respectively and annual cash inflows of Rs.5 million respectively. 4 35. 6266 243. 16. 0 11. = 51. Low demand 0. 2. the demand would be high or 246. -50000 14. If the product is introduced only in Western India. 7. Cash Factor: αt =1 ent Factor 9.84 25. Support your advice with appropriate reasoning.6. 10000 18. 0. Presen 232. 9200 20. Y 6. 1 17. 3. 248. Cryonics can evaluate the project to determine whether it should cover the entire country.08t value at 8% t Value 233. 12069 238. 0. -50000 234. 0.92 19. 2 23.50 million.10 million and Rs. 10. 1. 258. 251. 48. 21596 236.735 39.10 255. 47. Certain 229. 8519 235. 247. 40.20 million and Rs. 15200 32. The product. 1 13. After two years. which can be introduced initially in Western India or in the entire country. For such expansion. 0. 25200 26. Solution: 226. 0. 46. 0. All India 252. a 5. low with probabilities of 0.76 31. Cryonics Limited is planning to launch a new product. 245. 249. 10000 42. 4. 228. 0. 1 15. 28. 0. 227.6 43. will have a life of 5 years.6 and 0.681 45. 4086 240.8 and 0. 34. 9996 239. High demand Low demand 254.30 million. 50.857 27. 237. High demand 0. 250. 257. 6000 44. Certainty ty 8. in any case. r Flow . . 0.225.60 256.25 million respectively.0. e Equivalent Equival unt 231. Western India 253. (a) Set up a decision tree for the investment situation of Cryonics Limited. 6. The hurdle rate applicable to the project is 12 percent.40 0.90 0.12. If the product is introduced only in Western India. Disco 230. 30000 24.68 37. If the product is introduced in the entire country right in the beginning the demand would be high or low with probabilities of 0. the investment outlay will be Rs.25 million. 20000 30. (b) Advise Cryonics Limited on the investment policy it should follow. 5 41. 20000 36. if the product is introduced in the entire country the following probabilities would exist for high and low demand on an All-India basis. Based on the observed demand in Western India. it will have to incur an additional investment of Rs.4 and annual cash inflows of Rs. after which the plant will have a zero net salvage value. 13600 38.794 33. 242. 0. 244.926 21. 49.

.260.

3 India 3. All India 291. : 264. 75. 269.25 289. HD 10 103.9 C 3 101. – 25 = 12.5 2 C1 107.25 x PVIFA (3. 298.12 302. At D2 the payoffs of the All India and Western India alternatives are: 300. 111. 87. 0. the All-Indian option is truncated At D3 the payoffs of the All India and Western India alternatives are: 304.60 India HD : 20M 6. 58. 283. %) = 24.2 million 301. 265. 57.40 C4 All India 110. 271.61. 281. 67. 272. 74. All India : 19. = 15. 308. 61. 262. Working 263. 102.5 284. 86.25 = 21. 72.1 276. 288. D1 282.25 x PVIFA (3. 94.50 293. 287. 12. 117. 79. 59. 267. is more profitable. Western India : 10 x PVIFA (3.6 290.4 297. 299. 273.25 LD Western 116.2 million Western India 6. C2 0. HD: 20 M All 100. 66. .0 307. 90. All India : 15. 73. 64. 0. 278. 119. 70. 0.12%) 305. 294.5 x PVIFA (3. 89. . 77.2 Western 10 HD : 20 M 109.25 3 0. 84. 85. 266. 115. . 296. 91.0 million Since the Western India option303. 270. 275.3 -30 106.5 295. Western 108. 285. 274. India 0.12%) 306. 279. 92. 280. 1 D LD : 12.29 0. 118. D6.8 LD 112. 88. M 0. 93. 286. LD : 12. 292. India -25 62. 76. 277. 63.261.12%) . 268. 60.

At C2 the expected payoff is329.25 million.4 ] x PVIFA 331.2 [ 6. 134. 313. 135.736 + 15 x 0. = 0.12%) 332. 140. 320.55 million.56 = 33. 312. 123. + 0. 311.797] 321. policy is to choose the all-India alternative and continue 336. Magna Oil is wondering whether to drill oil in a certain basin. 339. The probability of getting oil at that depth is 0. the present value of oil obtained will be Rs.30 million. What is the optimal strategy for Magna Oil. (5. 121. 324. 24 x PVIF (2.2 [ 6. : 316.8 [ 10 x 1.12%) + 15 x PVIF(2. 310.96] = 29.25 x PVIFA (2.8 [ 10 x PVIFA (2. 126.5 x 0. 128.13] 325. Magna can drill another 500 metres at a cost of Rs. + 0. 326. If the well turns out to be dry. Draw the decision tree. = 0.120. the probability of striking oil at 1000 metres is 0. = 61.36 + 19. 334. 314. 124. 132.19 327.75 328. 7. 133. : 330.20 million.29 333. 130.6 + 12.+ 4.25 x 1. At C1 the expected payoff is315. 337. 338. 122. If it does so. 129.8 [ 17. The appropriate investment 335. 138.5 and the present value of oil obtained will be Rs. [ 20 x 0.12%)] 318. 136. 127.12%)] 319. 139.2 [ 10. 131. The cost of drilling a 500 metre well is Rs. 125.797] 323. If oil is struck.12%) +317. 322. 309. .6. 0. 137. + 0.736 + 24 x 0.85 + 11.

5 0 0. 347. 343. 346. 353. 360. Working: Oil Oil 30 55 0.5 Drill 500 Drill 19 27. 345. 356.4 Do nothing 0 0 Do nothing Do nothing . 348.5 -20 -25 -1 Dry Dry 0 2. 358. 342. 354. 351. 357. 350.6 0. 359. 344. 349.340. 355. 341. 352.

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