Concept explainers
Scenario Analysis is a technique used to identify the project’s risk and compare the bad and good circumstances with the base case scenario. It considers both the 1) sensitivity of the project’s
To carry out the scenario analysis, it is required to calculate the NPV of worst case, best case and base case, followed by the calculation of its standard deviation and co-efficient of variation. If the co-efficient of variation is higher than the average project of the company, the project should be rejected.
Expected NPV, Standard deviation of NPVs and co-efficient of variation of NPVs are calculated as below:
Here,
Probabilities of the occurrence is “
NPV for each probability is “
Standard deviation of NPVs is “
Co-efficient of Variation of NPVs is “
After conducting a scenario analysis, it is estimated, that the NPV of the project for all the three scenarios is as follows. Determine whether the project should be accepted or rejected if the maximum allowable co-efficient of variation is 0.8.
Scenario | Probability | NPV |
Best Case | 20% | $31,500 |
Base Case | 70% | $19,800 |
Worst Case | 10% | -$20,100 |
Want to see the full answer?
Check out a sample textbook solution- Desai Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. No change in net operating working capital would be required. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. What is the project's expected NPV? 10.0% $200,000 39,000 $25.00 WACC Net investment cost (depreciable basis) Units sold Average price per unit, Year 1 Fixed op. costs excl. depr. (constant) Variable op. cost/unit, Year 1 Annual depreciation rate Expected inflation rate per year Tax rate Oa. -$64.886 Ob. -$66,833 Oc. -$72,673 O d. -$73,970 O e. -$60,993 $150,000 $20.20 33.333% 5.00% 40.0%arrow_forwardAdam Andler Corp is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. What is the project's expected NPV? Do not round the intermediate calculations and round the final answer to the nearest whole number. WACC or cost of capital Net investment cost (depreciable basis) The salvage value of its equipment No other fixed assets will be acquired for following years The company will require an increase in net working capital at the $10,000 beginning The company will liquidate all working capital at the end of the project -10,000 Units sold (constant through years) 60,000 $30.00 $50,000 $17.00 Average price per unit, Year 1 Fixed operating…arrow_forward1. Desai Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. No change in net operating working capital would be required. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. What is the project's expected NPV? Do not round the intermediate calculations and round the final answer to the nearest whole number. WACC 10.0% Net investment cost (depreciable basis) Units sold $200,000 40,000 $25.00 Average price per unit, Year 1 Fixed op. cost excl. depr. (constant) Variable op. cost/unit, Year 1 Annual depreciation rate Expected inflation rate per year Tax rate $150,000 $20.20 33.333% 5.00%…arrow_forward
- Your boss wants you to conduct a sensitivity and scenario analysis to determine whether the following project is a winner. You are entering an established market, and you know the market size will be 1,100,000 units. You are unsure of your exact market share, the price you will be able to charge, and your variable cost per unit, but have determined a range of possible values for each (in the table below). Your initial investment cost is $150 million, and that investment will depreciate in straight-line form over the 20-year life of the project. There are no new NWC requirements, and there will be no salvage value at the end of the 20 years. The tax rate is 35%. The discount rate is 18%. a) Use the following table to conduct a full sensitivity analysis for the project. Make sure to include the NPV for the expected outcome as part of the full sensitivity analysis. Also add the best- and worst-case scenarios to the full sensitivity analysis. Show all of your work (written out, not an…arrow_forwardYou begin by trying to eliminate any proposals that are not yielding the company's minimum required rate of return of 20%. Complete the following table, and decide whether Alpha, Beta, and/or Gamma should be eliminated because the average rate of return of their project is less than the company's minimum required rate of return. Complete the following table. Enter the average rates of return as percentages rounded to two decimal places. Estimated Average Average Average Rate Accept or Proposal Annual Income Investment of Return Reject Alpha $ 2$ % Аcсept Beta Reject Gamma Аcсept Feedback V Check My Work Review the definition of average rate of return, and plug the relevant numbers into the formula from the data given. Cash Payback Method You've decided to confirm your results from the average rate of return by using the cash payback method. Using the following table, compute the cash payback period of each investment. If required, round the number of years in the cash payback period to…arrow_forwardHeckrwee Industries is considering a project that would require an initial investment of $101,000. The project would result in cost savings of $62,000 in year 1 and $70,000 in year 2. The internal rate of return is a.between 18% and 20%. b.between 16% and 17%. c.under 15%. d.None of these choices are correct.arrow_forward
- As a financial analyst, you are tasked with evaluating a capital-budgeting project. You were instructed to use the IRR method, and you need to determine an appropriate hurdle rate. The risk-free rate is 4%, and the expected market rate of return is 11%. Your company has a beta of 0.75, and the project that you are evaluating is considered to have risk equal to the average project that the company has accepted in the past. According to CAPM, the appropriate hurdle rate would be A. 15%. B. 9.25%. C. 4%. D. 11%. E. 0.75%arrow_forwardCelestial Crane Cosmetics is analyzing a project that requires an initial investment of $3,225,000. The project's expected cash flows are: Year Cash Flow Year 1 $375,000 Year 2 -125,000 Year 3 500,000 Year 4 400,000 If the company's WACC is 8% and the project has the same risk as the firm's average project, what is the project's modified internal rate of return (MIRR)? Should you accept or reject this project?arrow_forwardTexas Instruments is concerned that the estimated future operating costs of its soon-to-be-purchased equipment may not be very accurate. Let's say, the fixed production costs end up being 15% higher than what the company's research team has estimated, and the variable production costs will on the other hand be 8% lower. Clearly, this will affect the valuation of the project. But to which extent?? To see the extent of the effect on the project's current value, one should perform calculations known as analysis. Multiple Choice break-even scenario O sensitivity O equivalent cost homemadearrow_forward
- ZeeZee’s Construction Company has the opportunity to select one of four projects (A, B, C, or D) or the null (Do Nothing) alternative. Each project requires a single initial investment and has an internal rate of return as shown in the first table below. The second table shows the incremental IRR(s) for pairwise comparisons between each project and all other projects with a smaller initial investment. For each of the values of MARR below indicate which project is preferred based on an incremental IRR analysis. a. MARR = 50%. b. MARR = 41%. c. MARR = 25%.arrow_forwardJeweled Outlook is analyzing a proposed project with expected sales of 9,200 units, ±4 percent. The expected variable cost per unit is $26 and the expected fixed costs are $49,000. Cost estimates are considered accurate within a range of ±5 percent. The depreciation expense is $18,300. The sale price is estimated at $52 a unit, ±3 percent. If the company conducts a sensitivity analysis using a variable cost of $27, what will be the total variable cost estimate?arrow_forwardAssume a project has three variables: life, first cost, and annual cost. Assume there is no salvage value. For each variable there are three possible values as listed below. The firm uses an interest rate of 8 percent to evaluate engineering projects. For each variable, determine which value is "optimistic" and which is "pessimistic". The remaining value is "most likely". Compute each variable's estimated mean (using the "optimistic/most likely/pessimistic" formula) and using those computed mean values, compute the project's expected present value cost. First cost: -$480,000, -$620,000, -$860,000 Annual cost: -$75,000, -$85,000, -$110,000 Life: 8 years, 10 years, 24 years What is Expected Net Present Worth?arrow_forward
- EBK CONTEMPORARY FINANCIAL MANAGEMENTFinanceISBN:9781337514835Author:MOYERPublisher:CENGAGE LEARNING - CONSIGNMENTIntermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning