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# Scenario analysis

Scenario analysis can be used in a variety of instances with the main goal of predicting
the likely outcome of an event. People then use this prediction to make more informed
choices in the present, though there is always the risk that the prediction won't come to
fruition. This type of analysis is frequently used as a way to anticipate the value of an
investment.

Example
Ferndale Inc. is analyzing a capital budgeting expansion project with the following cash flow
forecasts:

3 year project
Unit sales = 1500 per year
Price = \$50
Variable cost = \$20 per unit
Fixed cost = \$5000 per year
FCIn = \$60000
Depreciated straight line over three years to book value of zero
NWCInv = \$15000
Salvage value at the end of three years = \$10000
Marginal tax rate = 40%
Cost of capital = 15%

A scenario analysis for the Ferndale capital budgeting is shown above. Notice that in the worst
case scenario unit sales, price, and salvage value are down 20% while fixed and variable cost are
up 20%. In best case scenario unit sales, price, and salvage value are up 20%, while costs are
down 20%.
Worst case

Base case

Best case

Unit sales

Down 20%

1500

Up 20%

Price

Down 20%

\$50

Up 20%

Variable cost

Up 20%

\$20

Down 20%

Fixed cost

Up 20%

\$5000

Down 20%

Salvage value

Down 20%

\$10000

Up 20%

Base case
Sales = 1500 x 50 = \$75,000
Cost = Fixed + Variable = 5000 + 20 (1500) = \$35,000
Depreciation = FCIn / # of years = 60000/3 = 20,000 per year

## Operating cash flows

CF = (S - C) (1 - T) + D T
CF1 = (75,000 35,000) (1 40%) + 20,000 X 40% = 32,000
CF2 = (75,000 35,000) (1 40%) + 20,000 X 40% = 32,000
CF3 = (75,000 35,000) (1 40%) + 20,000 X 40% = 32,000

## TNOCF = Sales + NWCInv T (sales book value)

= 10,000 + 15,000 - 40% (10,000 - 0) = 21,000

Cash out flow

= (75,000)

= 27,826

= 24,196.6

= 21,040.5

= 13,807.8

Base NPV

= 11,871

Worst case
Unit sales
Price
Variable cost
Fixed cost
Salvage value

Base case
1500
50
20
5000
10000

## Sales = 1200 x 40 = \$48,000

Cost = fixed + variable = 6000 + 24 (1200) = \$34,800
Depreciation = FCIn / # of years = 60000/3 = 20,000 per year

## Initial outlay = FCIn + NWCInv = 60,000 + 15,000 =\$ 75,000

Operating cash flows
CF = (S - C) (1 - T) + D T
CF1 = (48,000 34,800) (1 40%) + 20,000 X 40% = 15,920
CF2 = (48,000 34,800) (1 40%) + 20,000 X 40% = 15,920
CF3 = (48,000 34,800) (1 40%) + 20,000 X 40% = 15,920

## TNOCF = Sales + NWCInv T (sales book value)

= 8000+ 15,000 - 40% (8000 - 0) = 19,800

Cash outflow

= (75000)

= 13,843.5

= 12,037.9

= 10,467.66

= 13,018.82

Worst NPV

= (25,632.12)

1200
40
24
6000
8000

Best case
Unit sales
Price
Variable cost
Fixed cost
Salvage value

Base case
1500
50
20
5000
10000

## Sales = 1800 x 60 = \$108,000

Cost = fixed + variable = 4,000 + 60 (1,800) = \$32,800
Depreciation = FCIn / # of years = 60,000 /3 = 20,000 per year

## Initial outlay = FCIn + NWsCInv = 60,000 + 15,000 =\$ 75,000

Operating cash flows
CF = (S - C) (1 - T) + D T
CF1 = (108,000 32,800) (1 40%) + 20,000 X 40% = 53,120
CF2 = (108,000 32,800) (1 40%) + 20,000 X 40% = 53,120
CF3 = (108,000 32,800) (1 40%) + 20,000 X 40% = 53,120

## TNOCF = Sales + NWCInv T (sales book value)

= 12,000 + 15,000 - 40% (12,000 - 0) = 22,200

Cash outflow

= (75,000)

= 46,191.30

= 40,166.35

= 34,927.26

= 14,596.86

Best NPV

= 60,882

1800
60
16
4000
12000