3-1 Scenario Analysis: Project Risk Analysis-Comprehensive

3-1 SCENARIO ANALYSIS
Family security is considering the introduction of a child security product consisting of tiny
Global Positioning System (GPS) trackers that can be inserted in the sole of a child’s shoe. The
trackers allow parents to track the child if he or she were ever lost or abducted. The estimates,
plus or minus 10%, associated with this new product are as follows: Unit price: $125, Variable
costs per unit: $75, Fixed costs: $250,000 per year, Expected sales: 10,000 units per year.
Because this is a new product line, the firm’s analysts are not confident in their estimates and
would like to know how well the investment would fare if the estimates on the items listed above
are 10% higher or 10% lower than expected. Assume that this new product line will require an
initial outlay of $1 million, with no working capital investment, and will last for ten years, being
depreciated down to zero using straight-line depreciation. In addition, the firm’s management
uses a discount rate of 10% and a 34% tax rate in its project analyses.
a. Calculate the project’s NPV under each of the following sets of assumptions:
(1) the best-case scenario (use the high estimates—unit price 10% above expected, variable costs
10% less than expected, fixed costs 10% less than expected, and unit sales 10% higher than
expected),
(2) the base case using expected values, and
(3) the worst case scenario.
b. Given your estimates of the range of NPVs for the investment, what is your assessment of the
investment’s potential?
3-6 Project Risk Analysis—Comprehensive: Bridgeway Pharmaceuticals manufactures and

sells generic over-the-counter medications in plants located throughout the Western Hemisphere.
One of its plants is trying to decide whether to automate a portion of its packaging process by
purchasing an automated waste disposal and recycling machine. The proposed investment is
$400,000 to purchase the necessary equipment and get it into place. The machine will have a
five-year anticipated life and will be depreciated
at a rate of $80,000 per year, toward a zero anticipated salvage value. The firm’s analysts
estimate that the purchase of the new waste-handling system will bring annual cost savings of
$40,000 from reduced labor costs, $18,000 per year from reduced waste disposal costs, and
$200,000 per year from the sale of reclaimed plastic waste net of selling expenses.
Bridgeway requires a 20% return from capital investments and faces a 35% tax rate.
a. Using the estimates provided, should Bridgeway purchase the new automated waste-handling
system?
b. The manager at the plant where the handling system is being contemplated has raised some
questions regarding the potential savings from the system. He asked the financial analyst in
charge of preparing the proposal to evaluate the impact of variations in the price of plastic waste
materials, which have proven to be volatile in the past. Specifically, what would be the impact of
price reductions for the waste that drive the revenues from the sale of waste down to half their
estimated amounts in years 1 through 5?
3-3 SIMULATION ANALYSIS NEXTRON Distribution is performing an analysis of the cash

flows it hopes to earn from a major expansion of the firm’s operations into a new product line.
The estimates needed for computing the annual free cash flow for the first year of operations are
found below:
Construct a spreadsheet model for year 1 free cash flow. What is your estimate of the expected
cash flow?
3-2 BREAKEVEN SENSITIVITY ANALYSIS

a. Construct a spreadsheet model to compute free cash flow that relies on the following
assumptions or estimates:
b. What level of annual unit sales does it take for the investment to achieve a zero NPV?
Use your spreadsheet model to answer this question. (Hint: Use the Goal Seek function in
Excel.)
c. If unit sales were 15% higher than the base case, what unit price would it take for the
investment to achieve a zero NPV?
2-11 PROJECT VALUATION HMG Corporation is considering the manufacture of a new
chemical compound that is used to make high-pressure plastic containers. An investment of $4
million in plant and equipment is required. The firm estimates that the investment will have a
five-year life, and will use straight-line depreciation toward a zero salvage value. However, the
investment has an anticipated salvage value equal to 10% of its original cost. The number of
pounds (in millions) of the chemical compound that HMG expects to sell over the five-year life
of the project are as follows: 1.0, 1.5, 3.0, 3.5, and 2.0. To operate the new plant, HMG estimates
that it will incur additional fixed cash operating expenses of $1 million per year and variable
operating expenses equal to 45% of revenues. HMG also estimates that in year t it will need to
invest 10% of the anticipated increase in revenues for year t + 1 in net working capital. The price
per pound for the new compound is expected to be $2.00 in years 1 and 2, then $2.50 per pound
in years 3 through 5. HMG’s tax rate is 38%, and it requires a 15% rate of return on its new-
product investments.
a. Exhibit P2-11.1 contains projected cash flows for the entire life of the proposed investment.
Note that investment cash flow is derived from the additional revenues and costs associated with
the proposed investment. Verify the calculation of project cash flow for year 5.
b. Does this project create shareholder value? How much? Should HMG undertake the
investment? Explain your answer.
c. What if the estimate of the variable costs were to rise to 55%? Would this affect your
decision?
3-5 PROJECT RISK ANALYSIS—SENSITIVITY ANALYSIS Refer to the HMG example

found in Problem 2-11 (page 52) and answer the following questions: a. What are the key
sources of risk that you see in this project? b. Use the Goal Seek function in Excel to find the
breakeven values (i.e., values that force the project NPV to equal zero) for each of the following
variables: the initial CAPEX, the working capital percentage of revenue growth, variable cost
percentage of sales, and sales volume. (Hint: Scale the sales volume for all five years up and
down by the same percentage.) c. Which of the variables analyzed in Problem 3-5(b) do you
think is the greatest source of concern? What, if anything, could you do to reduce the risk of the
project? d. Should you always seek to reduce project risk?
3-7 PROJECT RISK ANALYSIS—BREAKEVEN SENSITIVITY The TitMar Motor

Company is considering the production of a new personal transportation vehicle (PTV). The
PTV would compete directly with the innovative new Segway. The PTV will utilize a threewheel
platform capable of carrying one rider for up to six hours per battery charge thanks to a new
battery system developed by TitMar. TitMar’s PTV will sell for substantially less than the
Segway but will offer equivalent features. The pro forma financials for the proposed PTV
project, including the forecasts and assumptions that underlie them, are set out in Exhibit P3-7.1.
Note that revenue is calculated as follows: price per unit * market share (%) * market size and
units sold = revenues/price per unit. The project offers an expected NPV of $9,526,209 and an
IRR of 39.82%. Given TitMar’s stated hurdle rate of 18%, the project looks like a winner. Even
though the project looks very good based on management’s estimates, it is risky and can turn
from a positive NPV investment to a negative one with relatively modest changes in the key
value drivers. Develop a spreadsheet model of the project valuation and answer the following
questions:
a. If the firm’s market share turns out to be only 5%, what happens to the project’s NPV and
IRR?
b. If the market share remains at 15% and the price of the PTV falls to $4,500, what is the
resulting NPV?
c/ Calculate the critical change ( %) of some following variables: Price per unit, market share,
market size (Year 1), Growth rate in market size beginning in Year 2, Unit variable cost, fixed
cost, tax rate, cost of capital, Investment in NWC.
Variables Estimated value Critical Critical % change
value( breakeven
value)

3-1 Scenario Analysis: Project Risk Analysis-Comprehensive

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3-1 Scenario Analysis: Project Risk Analysis-Comprehensive

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What are some of the key factors being analyzed in the project valuations?

What sources of risk does the manager raise regarding the waste handling system project?

3-1 SCENARIO ANALYSIS

3-6 Project Risk Analysis—Comprehensive: Bridgeway Pharmaceuticals manufactures and

3-3 SIMULATION ANALYSIS NEXTRON Distribution is performing an analysis of the cash

3-2 BREAKEVEN SENSITIVITY ANALYSIS

3-5 PROJECT RISK ANALYSIS—SENSITIVITY ANALYSIS Refer to the HMG example

3-7 PROJECT RISK ANALYSIS—BREAKEVEN SENSITIVITY The TitMar Motor

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