Scenario Ana l ysis. The most likely outcomes for a particular project are estimated as follows: Unit price: $50 Variable cost: $30 Fixed cost: $300,000 Expected sales: 30,000 units per year However, you recognize that some of these estimates are subject to error. Suppose that each variable may turn out to be either 10 percent higher or 10 percent lower than the initial esti- mate. The project will last for 10 years and requires an initial investment of $1 million, which will be depreciated straight-line over the project life to a final value of zero. The firms tax rate is 35 percent and the required rate of return is 14 percent. What is project NPV in the best-case scenario, that is, assuming all variables take on the best possible value? What about the worst-case scenario?

Answer Present value of interestfactor is calculated as |1 – [1 / (1 + required rate of return)^project horizon] / required rate of return| Scenarios Worst Base Best Variation -10% 0% 10% Unit Sale Price $45 $50 $55 Variable Cost $27 $30 $33 Contribution per unit (Sale price – variable cost) $18 $20 $22 Expected Sales volume $27,000 $30,000 $33,000 Total contribution $486,000 $600,000 $726,000 Less: Fixed Cost $270,000 $300,000 $330,000 Profit before depreciation and taxes $216,000 $300,000 $396,000 Initial investment $1,000,000 $1,000,000 $1,000,000 Project life (Yrs) 10 10 10 Salvage value 0 0 0 Annual Depreciation $100,000 $100,000 $100,000 Profit after depreciatio but…

re tax $116,000 $200,000 $296,000 Tax @ 35% $40,600 $70,000 $103,600 Profit after tax $75,400 $130,000 $192,400 Add: Depreciation ( being non-cash item) $100,000 $100,000 $100,000 Annual cash flows $175,400 $230,000 $292,400 Present value of interest factor (PVIF) @ 14% 5.22 5.22 5.22 Present value of cash flows (Annual cash flows * PVIF) $914,907 $1,199,707 $1,525,192 NPV (Present value of cash flows – initial investment) ($85,093) $199,707 $525,192