Financial

Management Task
By : Herlina Utamawati (attendee's number : 14 /7A Alih Program)

Chapter 13 – Risk Analysis and Project Evaluating

STUDY PROBLEMS 13-7 Comprehensive risk analysis

Blinkeria is considering introducing a new line of hand scanners that can be used to copy material and then
download it into personal computer. These scanners are expected to sales for an average price of $100 each,
and the company analyst performing the analys expect that the firm can sell 100,000 units per year at this
price for period of five years, after which time they expect demand for the product to end as result of new
technology. In addition, variable cost are expected to be $20 per unit while fixed costs, not including
depreciation, are forecast to be $1,000,000 per year. To manufacture this product, Blinkeria will need to buy
a computerized production machine for $10 million that has no residual or salvage value, and will have an
expected life of five years. In addition, the firm expects it will 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:

Initial cost of the machine $10,000,000

Expected life 5 years
Salvage value of the machine $0
Working capital requirement $300,000
Depreciation method Straight line
Depreciation expense $2,000,000 per year
Cash fixed-cost --- Excluding depreciation $1,000,000 per year
Variable costs per unit $20
Required rate of return or cost of capital 10%
Tax rate 34%

a. Calculate the project’s NPV.

b. Determine the sensitivity of the project’s NPV to a 10% decrease in the number of units sold.
c. Determine the sensitivity of the project’s NPV to a 10% decrease in the cost per unit.
(ASSUMPTION: cost per unit = sales price per unit, because element of cost (Variable and fixed-cost) had
been mentioned in question (d) and (e))
d. Determine the sensitivity of the project’s NPV to a 10% increase in the Variable cost per unit.
e. Determine the sensitivity of the project’s NPV to a 10% increase in the annual fixed operating cost.
(ASSUMPTION: annual fixed operating cost other than depreciation)
f. Use scenario analysis to evaluate the project’s NPV under worst and best case scenarios for the project’s
value drivers. The value for the expected or base-case along with the worst- and best-case scenarios are
listed below:

Expected or Base-Case Worst-Case Best-Case
Unit sales 100,000 70,000 130,000
Price per unit $100 $90 $120
Variable cost per unit $(20) $(22) $(18)
Cash fixed costs per year $(1,000,000) $(1,200,000) $(900,000)
Depreciation Expense $(2,000,000) $(2,000,000) $(2,000,000)
STEP 1 PICTURE THE PROBLEM
NPV of the project is the present value of the project’s future cash flows for 5 years with the required rate of
return 10%. As shows at timeline below:

k = 10%

Time Period (years) 0 1 2 3 4 5 years

Cash Flow (CF0) CF1 CF2 CF3 CF4 CF5

Present Value = ?

To evaluate the sensitivity of the project’s NPV to uncertainty surrounding the project’s value driver, we
analyze the effects of the changes in the value drivers (unit sales, price per unit, variable cost per unit, and
annual fixed operating cost other than depreciation). Specially, we consider each of the following changes:

Value Driver
Unit sales (-10%)
Price per unit (-10%)
Variable cost per unit (+10%)
Cash fixed cost per year (+10%)

The value for the expected or base-case along with the worst- and best-case scenarios are listed below:

Expected or Base-Case Worst-Case Best-Case

Unit sales 100,000 70,000 130,000
Price per unit $100 $90 $120
Variable cost per unit $(20) $(22) $(18)
Cash fixed costs per year $(1,000,000) $(1,200,000) $(900,000)
Depreciation Expense $(2,000,000) $(2,000,000) $(2,000,000)

STEP 2 DECIDE ON A SOLUTION STRATEGY

Estimate the expected NPV of the project by calculating project’s future cash flows for 5 years, then calculate
the present value of the project’s future cash flows with the required rate of return.

The objective of the sensitivity analysis is to explore the effects of the prescribed changes in the value drivers
on the project’s NPV. In this instance, we estimates of each of the value driver that deviate 10% from their
expected or base-case value in an adverse direction (lead to reduction of NPV). Then comparing the resulting
NPV with the base-case NPV(calculated using the expected values for all the value driver) in order to
determine which value driver has the greatest influence on NPV.

The objective of scenario analysis is to explore the sensitivity of the project’s NPV to different scenarios that
are defined in terms of the estimated values for each of the project’s value drivers. In this instance we have
two scenarios corresponding to the worst and best-case outcomes for the project.

STEP 3 SOLVE

a. Calculate the project’s NPV.

The cash flows for the base-case is calculated by completing income statement below:
Base-Case Year 0 Year 1 - 4 Year 5
Revenues (100,000 unit x $100) $ 10,000,000 $ 10,000,000
Less: Variable cost ($20/unit) (2,000,000) (2,000,000)
Less: Fixed Cash (1,000,000) (1,000,000)
Gross Profit $ 7,000,000 $ 7,000,000
Less: Depreciation expense (2,000,000) (2,000,000)
Net Operating Income $ 5,000,000 $ 5,000,000
Less: Income Tax expense (1,700,000) (1,700,000)
Net Operating Profit after Tax (NOPAT) $ 3,300,000 $ 3,300,000
Add: Depreciation expense 2,000,000 2,000,000
Less: Increase in CAPEX $ (10,000,000) - -
Less: Increase in working capital (300,000) - 300,000
Free Cash Flow (FCF) $ (10,300,000) $ 5,300,000 $ 5,600,000

𝐂𝐅𝟏 𝐂𝐅𝟐 𝐂𝐅𝟑 𝐂𝐅𝟒 𝐂𝐅𝟓
NPV = CF0 + + + + +
(𝟏%𝒌) (𝟏%𝒌)𝟐 (𝟏%𝒌)𝟑 (𝟏%𝒌)𝟒 (𝟏%𝒌)𝟓
$𝟓,𝟑𝟎𝟎,𝟎𝟎𝟎 $𝟓,𝟑𝟎𝟎,𝟎𝟎𝟎 $𝟓,𝟑𝟎𝟎,𝟎𝟎𝟎 $𝟓,𝟑𝟎𝟎,𝟎𝟎𝟎 $𝟓,𝟔𝟎𝟎,𝟎𝟎𝟎
= $(10,300,000) + + + + +
(𝟏%𝟎.𝟏) (𝟏%𝟎.𝟏)𝟐 (𝟏%𝟎.𝟏)𝟑 (𝟏%𝟎.𝟏)𝟒 (𝟏%𝟎.𝟏)𝟓
= $(10,300,000) + $4,818,181.82 + $4,380,165.29 + $3,981,968.45 + $3,619,971.31 + 3,477,159.41
= $(10,300,000) + $20,277,446.27
= $9,977,446.28

or to calculate present value of the future cash flow for the base case we can use the time value of money
features on financial calculator

enter 5 10 5,300,000 300,000

N i/Y PV PMT FV
Solve for -20,277,446

NPV = $(10,300,000) + $20,277,446 = $9,977,446

b. Determine the sensitivity of the project’s NPV to a 10% decrease in the number of units sold.
Decrease 10% number unit sold Year 0 Year 1 - 4 Year 5
Revenues (90,000 unit x $100) $ 9,000,000 $ 9,000,000
Less: Variable cost ($20/unit) (1,800,000) (1,800,000)
Less: Fixed Cash (1,000,000) (1,000,000)
Gross Profit $ 6,200,000 $ 6,200,000
Less: Depreciation expense (2,000,000) (2,000,000)
Net Operating Income $ 4,200,000 $ 4,200,000
Less: Income Tax expense (1,428,000) (1,428,000)
Net Operating Profit after Tax (NOPAT) $ 2,772,000 $ 2,772,000
Add: Depreciation expense 2,000,000 2,000,000
Less: Increase in CAPEX $ (10,000,000) - -
Less: Increase in working capital (300,000) - 300,000
Free Cash Flow (FCF) $ (10,300,000) $ 4,772,000 $ 5,072,000
 To calculate the present value of the future cash flow for this case we can use the time value of money
features on financial calculator:

enter 5 10 4,772,000 300,000

N i/Y PV PMT FV
Solve for -18,275,911

The NPV for this scenario will be:

NPV = $(10,300,000) + $18,275,911 = $7,975,911

c. Determine the sensitivity of the project’s NPV to a 10% decrease in the cost per unit.
(ASSUMPTION: cost per unit = sales price per unit, because element of cost (Variable and fixed-cost)
had been mentioned in question (d) and (e))

Decrease 10% sales price per unit Year 0 Year 1 - 4 Year 5
Revenues (100,000 unit x $90) $ 9,000,000 $ 9,000,000
Less: Variable cost ($20/unit) (2,000,000) (2,000,000)
Less: Fixed Cash (1,000,000) (1,000,000)
Gross Profit $ 6,000,000 $ 6,000,000
Less: Depreciation expense (2,000,000) (2,000,000)
Net Operating Income $ 4,000,000 $ 4,000,000
Less: Income Tax expense (1,360,000) (1,360,000)
Net Operating Profit after Tax (NOPAT) $ 2,640,000 $ 2,640,000
Add: Depreciation expense 2,000,000 2,000,000
Less: Increase in CAPEX $ (10,000,000) - -
Less: Increase in working capital (300,000) - 300,000
Free Cash Flow (FCF) $ (10,300,000) $ 4,640,000 $ 4,940,000

To calculate the present value of the future cash flow for this case we can use the time value of money
features on financial calculator:

enter 5 10 4,640,000 300,000

N i/Y PV PMT FV
Solve for -17,775,527

The NPV for this scenario will be:

NPV = $(10,300,000) + $17,775,527 = $7,475,527

d. Determine the sensitivity of the project’s NPV to a 10% increase in the Variable cost per unit.
Increase 10% Variable Cost Year 0 Year 1 - 4 Year 5
Revenues (100,000 unit x $100) $ 10,000,000 $ 10,000,000
Less: Variable cost ($22/unit) (2,200,000) (2,200,000)
Less: Fixed Cash (1,000,000) (1,000,000)
Gross Profit $ 6,800,000 $ 6,800,000
Less: Depreciation expense (2,000,000) (2,000,000)
Net Operating Income $ 4,800,000 $ 4,800,000
Less: Income Tax expense (1,632,000) (1,632,000)
Net Operating Profit after Tax (NOPAT) $ 3,168,000 $ 3,168,000
Add: Depreciation expense 2,000,000 2,000,000
Less: Increase in CAPEX $ (10,000,000) - -
Less: Increase in working capital (300,000) - 300,000
Free Cash Flow (FCF) $ (10,300,000) $ 5,168,000 $ 5,168,000
To calculate the present value of the future cash flow for this case we can use the time value of money
features on financial calculator:

enter 5 10 5,168,000 300,000

N i/Y PV PMT FV
Solve for -19,777,062

The NPV for this scenario will be:

NPV = $(10,300,000) + $19,777,062 = $9,477,062

e. Determine the sensitivity of the project’s NPV to a 10% increase in the annual fixed operating cost.
(ASSUMPTION: annual fixed operating cost other than depreciation)
Increase 10% annual fixed cost Year 0 Year 1 - 4 Year 5
Revenues (100,000 unit x $100) $ 10,000,000 $ 10,000,000
Less: Variable cost ($20/unit) (2,000,000) (2,000,000)
Less: Fixed Cash (1,100,000) (1,100,000)
Gross Profit $ 6,900,000 $ 6,900,000
Less: Depreciation expense (2,000,000) (2,000,000)
Net Operating Income $ 4,900,000 $ 4,900,000
Less: Income Tax expense (1,666,000) (1,666,000)
Net Operating Profit after Tax (NOPAT) $ 3,234,000 $ 3,234,000
Add: Depreciation expense 2,000,000 2,000,000
Less: Increase in CAPEX $ (10,000,000) - -
Less: Increase in working capital (300,000) - 300,000
Free Cash Flow (FCF) $ (10,300,000) $ 5,234,000 $ 5,534,000

To calculate the present value of the future cash flow for this case we can use the time value of money
features on financial calculator:

enter 5 10 5,234,000 300,000

N i/Y PV PMT FV
Solve for -20,027,254

 The NPV for this scenario will be:

NPV = $(10,300,000) + $20,027,254 = $9,727,254

f. Use scenario analysis to evaluate the project’s NPV under worst and best case scenarios for the
project’s value drivers.

Worst-Case Best-Case
Year 1-4 Year 5 Year 1-4 Year 5
Revenues $ 6,300,000 $ 6,300,000 $ 15,600,000 $ 15,600,000
Less: Variable cost (1,540,000) (1,540,000) (2,340,000) (2,340,000)
Less: Fixed Cash (1,200,000) (1,200,000) (900,000) (900,000)
Gross Profit $ 3,560,000 $ 3,560,000 $ 12,360,000 $ 12,360,000
Less: Depreciation expense (2,000,000) (2,000,000) (2,000,000) (2,000,000)
Net Operating Income $ 1,560,000 $ 1,560,000 $ 10,360,000 $ 10,360,000
Less: Income Tax expense (530,400) (530,400) (3,522,400) (3,522,400)
Net Operating Profit after Tax (NOPAT) $ 1,029,600 $ 1,029,600 $ 6,837,600 $ 6,837,600
Add: Depreciation expense 2,000,000 2,000,000 2,000,000 2,000,000
Less: Increase in CAPEX - - - -
Less: Increase in working capital - 300,000 - 300,000
Free Cash Flow (FCF) $ 3,029,600 $ 3,329,600 $ 8,837,600 $ 9,137,600

To calculate the present value of the future cash flow for the Worst-case we can use the time value of
money features on financial calculator:

enter 5 10 3,029,600 300,000

N i/Y PV PMT FV
Solve for -11,670,844

The NPV for this scenario will be:

NPV = $(10,300,000) + $11,670,844 = $1,370,844

To calculate the present value of the future cash flow for the Best-case we can use the time value of money
features on financial calculator:

enter 5 10 8,837,600 300,000

N i/Y PV PMT FV
Solve for -33,687,734

The NPV for this scenario will be:

NPV = $(10,300,000) + $33,687,734 = $23,387,734

STEP 4 ANALYZE
Recalculating project NPV by changing each value driver by 10% we get the following results:

Value driver Expected NPV Revised NPV % Change in NPV

Unit sales (-10%) $9,977,446 $7,975,911 -20.06%
Price per unit (-10%) $9,977,446 $7,475,527 -25.08%
Variable cost per unit (+10%) $9,977,446 $9,477,062 -5.02%
Cash fixed cost per year (+10%) $9,977,446 $9,727,254 -2.51%

Ø 10% adverse change from the estimated value of the four value driver result decrease of the NPV’s project.
Moreover, the most critical value driver is price per unit, followed closely by the number of unit sold.
Ø The result of this analysis suggest two courses of action. First, Blinkeria’s management should make sure
that they are as comfortable as possible with their price per unit forecast as well their estimate of the
number of unit sold. This might entail using additional market research to explore the pricing and volume
issues.
Ø Second, should the project be implemented, it is imperative that the company monitor these two critical
value driver (price per unit and number of unit sold) very closely so that they can react quickly if an adverse
change in either variable occur.

Recalculating project NPV for both sets of value driver results in the following estimates of project NPV:

Scenario NOPAT Free Cash Flows NPV

(Years 1-4)
Expected or Base-Case $3,300,000 $5,300,000 $9,977,446
Worst-Case $1,029,600 $3,029,600 $1,370,844
Best-Case $6,837,600 $8,837,600 $23,387,734

Examination of the worst and best-case scenario for the project indicates that although the project is expected
to produce an NPV of $9,977,446, the NPV might be as high as $23,387,734 or as low as $1,370,844. Clearly,
this is a risky investment opportunity. If the very low NPV of the worst-case scenario is particularly
troublesome to the firm’s management, they might consider an alternative course of action that reduces the
likelihood of this worst-case result.

STUDY PROBLEMS 13-11 Break Even Analysis

Niece Equipment rentals of Del Valle, TX has recently been approached about the prospect of purchasing a
large construction crane. The crane rent for $500 an hour but operator, fuel, insurance and miscellaneous
expense run $200 an hour when the crane is in use. The company owner estimates that it will cost $1,000 a
month to store an maintain the crane and the annual depreciation expense is $50,000.

a. Calculate the accounting break-even number of annual rental hours needed to produce zero operating
earnings from the crane (before taxes)
b. Calculate the cash break-even point. If we ignore non-cash expense such as depreciation in the break even
calculation, how many hours must the crane be rented in order to break even on a cash basis?
c. Why do we have two different break-even point? What does each one tell you?

 STEP 1 PICTURE THE PROBLEM

The annual cost structure for the proposed investment is comprised of total fixed costs plus variable costs,
which are different for each possible level of annual rental hours:

$250,000

$200,000
Total Variable Costs=
$200 x hours rent
$150,000
$ COST

Total Fixed Costs equal the sum of

cash fixed costs of $12,000 per year and
$100,000 depreciation expense $50,000 per year

$50,000

$0
200 400 600 800 1,000
ANNUAL RENTAL HOURS

Total Variable Costs Total Fixed Costs

Total Variable Costs = $200 per hour X annual rental hours

Total Fixed Costs equal the sum of cash fixed costs of $12,000/year and depreciation expense $50,000/year

Total Fixed Costs = $12,000 + $50,000 = $62,000

STEP 2 DECIDE ON SOLUTION STRATEGY

The accounting break-even model summarizes this relationship:

23456 789:; <3=4= (7)

QAccounting Break-even =
>?8@: A:? BC84 > D E5?85F6: <3=4 A:? BC84 (E)

In addition, to calculate the cash break-even point summarizes this relationship:

23456 789:; <3=4= 7 D G:A?:@85483C (G)

QCash Break-even =
>?8@: A:? BC84 > D E5?85F6: <3=4 A:? BC84 (E)

STEP 3 SOLVE
a. Calculate the accounting break-even number of annual rental hours needed to produce zero operating
earnings from the crane (before taxes)
The accounting break-even number of annual rental hours is given by:
23456 789:; <3=4= (7)
QAccounting Break-even =
>?8@: A:? BC84 > D E5?85F6: <3=4 A:? BC84 (E)

$HI,JJJ
QAccounting Break-even = = 207 hours
$KJJ A:? L3B? D $IJJ A:? L3B?

b. Calculate the cash break-even point. If we ignore non-cash expense such as depreciation in the break
even calculation, how many hours must the crane be rented in order to break even on a cash basis?
The cash break-even point of annual rental hours is given by:
23456 789:; <3=4= 7 D G:A?:@85483C (G)
QCash Break-even =
>?8@: A:? BC84 > D E5?85F6: <3=4 A:? BC84 (E)

$HI,JJJ D$KJ,JJJ
QCash Break-even = = 40 hours
$KJJ A:? L3B? D$IJJ A:? L3B?

c. Why do we have two different break-even point? What does each one tell you?
The accounting break-even point tells us the level of annual rental hours necessary to cover our total fixed
and variable operating costs where total fixed costs include both cash fixed costs and depreciation expense
(which is not a cash expense for the period). The cash break-even point tells us the level of annual rental
hours where we have covered our cash fixed costs (ignoring depreciation) and as a result our cash flow is
zero.

STEP 4 ANALYZE
Graphically, we can locate the accounting break-even output level as follows:

$450,000

$400,000

$350,000
$ Revenue and Cost

$300,000 Total Revenues = $500 X 207 hours

$250,000 = $103,500
$200,000

$150,000

$100,000 Total Costs = Fixed Costs + Variable Costs

= $62,000 + ($200 x 207 hours)
$50,000
= $103,400
$0
0 200 400 600 800 1000
Annual Rental Hours

Total Revenues Total Costs

Break-even analysis provides us with an understanding of what level of annual rental hours we need to break
even in accounting sense - that is, what levels of annual rental hours we need in order to cover our total fixed
and variable costs resulting in net operating income equaling zero. Often managers are concerned with
whether a project contributes to a firms’s accounting earnings; accounting break even analysis tells us if it
does. A project that does not break even reduces the firm’s earnings, whereas a project that breaks even will
add to a firm’s earnings.

Still, we must keep in mind that just breaking even does not mean that shareholders will benefit. In fact,
projects that merely break even in accounting sense have negative NPV’s and result in a loss of shareholder
value. That’s because we do include opportunity cost. The money spent on a project that merely breaks even
simply covers the project’s costs, but it does not provide investors with their required rate of return. In effect,
it ignores the opportunity cost of money. Still, break-even analysis provides manager with excellent insight
into what might happen if the projected level of annual rental hours is not reached.

STUDY PROBLEMS 13-15 Real Options and capital budgeting

You are considering introducing a new Tex-Mex-Thai fusion restaurant. The initial outlay on this new
restaurants is $6 million, and the present value of the free cash flows (excluding the initial outlay) is $5
million, such that the project has a negative expected NPV of $1 million. Looking closer, you find that there
is a 50% chance that this new restaurant will be well received and will produce annual cash flows of
$800,000 per year forever (a perpetuity). While there is a 50% chance of it producing a cash flows of only
$200,000 per year forever (a perpetuity) if it isn’t received well. The required rate of return you use to
discount the project cash flows is 10%, however, if the new restaurant is successful, you will be able to build
10 more of them and they will have costs and cash flows similar to the successful restaurant cash flows.

a. In spite of the fact that the first restaurant has a negative NPV, should you build it anyway? Why or why
not?
b. What is the expected NPV for this project if only one restaurant is built but isn’t well received? What is
the expected NPV for this project if 10 more are built after one year and are well received?

STEP 1 PICTURE THE PROBLEM

Graphically, this can be viewed as:

Build 1 Tex-Mex-Thai Fussion at a

cost of $6 million

Probability unfavourably Probability favourably

received = 50% received = 50%

Don't build any more

Build 10 more restaurants:
restaurants:
NPV = (10 + 1) x $2,000,000
NPV = -$4,000,000

STEP 2 DECIDE ON SOLUTION STRATEGY
Determine an NPV for this project assuming you will build 11 identical Tex-Mex-Thai fusion restaurants if the
project is favorably received, and assuming you will not build any additional restaurants if it is not favorably
received.

STEP 3 SOLVE
a. In spite of the fact that the first restaurant has a negative NPV, should you build it anyway? Why or why
not?

Yes, because if the company does not open the first restaurant it will never know whether this type of
restaurant will be succesfull.

b. What is the expected NPV for this project if only one restaurant is built but isn’t well received? What is
the expected NPV for this project if 10 more are built after one year and are well received?

In this problem, we have:

initial outlay = $6,000,000
discount rate = 10%
50% chance the new restaurant will be favourably received à produce a perpetuity $800,000 a year
50% chance the new restaurant will be unfavourably received à produce a perpetuity $200,000 a year

The NPV if favourably received is:

$MJJ,JJJ
NPV = - $6,000.000 = $8,000,000 - $6,000,000 = $2,000,000
NJ%

The NPV if unfavourably received is:

$IJJ,JJJ
NPV = - $6,000.000 = $2,000,000 - $6,000,000 = -$4,000,000
NJ%

Assuming we will open 10 more Tex-Mex Thai fussion restaurants if it is favourably received and only one
if it is unfavourably received, and the outcomes are a 50% probability of favourably received and a 50%
probability of unfavourably received:
NPV = (-$4,000,000 x 0.5) + ($2,000,000 x 0.5 x (10+1))

= -$2,000,000 + $11,000,000
= $9,000,000

STEP 4 ANALYZE
Without the option to expand, this project would have an expected NPV of -$1,000,000,

NPV = (-$4,000,000 x 0.5) + ($2,000,000 x 0.5) = -$2,000,000 + $1,000,000 = -$1,000,000

However, adding the option to expand allows the firm to take advantage of the increased certainty that the
project will be received favourably and expand on it. This partially explains why many large restaurant
chains introduce new theme restaurant in the hopes that they succeed. If they do, the chain can open
additional new restaurant or franchise them.