In the ongoing operations, there is stiff competition being faced and hence to deal with the same, a new product launch has been proposed by the company. This memo assumes significance as it highlights the summarised findings of the financial analysis conducted in wake of this project considering the fact that this project is riskier than the current operations of the company. The financial analysis involves base case cash flows and feasibility analysis besides conducting analysis uncertainty through the use of specialised tools. Based on this analysis, key recommendations are also summarised which could help you in making the appropriate decision. The project cash flow estimation is based on following mentioned key observations.
- The factory premises which have been proposed to be used setting up the manufacturing unit in relation to the new product is currently in use and hence a rental income of $ 250,000 on an annual basis is earned by the company which is reflected in the income statement. However now when the manufacturing is carried out in the factory, this rental income would be foregone by the company and this would be highlighted in the cash flow follows as opportunity cost related to the use of factory premises (Petty et. al., 2015).
- An external consultant was hired in order to estimate the likely demand for the product taking into consideration that this is a new product. The consultant was paid a fee which has been discarded for the cash flow analysis shown below. This treatment has been extended owing to external consultant cost being a sunk cost for which recovery cannot happen even if the proposed project is scrapped (Northington, 2015).
- Also, assumption regarding cash flow pattern has been made so as to assist in application of various capital budgeting tools which are based on time value of money and hence require cash flows to happen at a particular time usually year end (Damodaran, 2015).
Incremental Cash Flows
The project related incremental cash flows that are expected to be witnessed during the five year useful life of the project are as follows.
Financial Feasibility (Base Case)
Taking into consideration the above incremental cash flows, the key capital budgeting tools have been applied assuming that the discount rate would remain as 10% despite higher risk associated. The respective values of these is summarised in the tabular format shown below.
The above computation results clearly highlight the financial feasibility of the base case related to the proposed project since on every parameter there is an acceptance for the project (Northington, 2015).
The project aims to manufacture a new product which deviates significantly from the current business operations of the firm. In such an environment, following two aspects can be significantly volatile.
- Discount rate since the project related risk is higher hence there is an risk of discount cost enhancing especially if the initial response to the project is not as per expectations.
- The estimation of precise response that the consumers would provide to the new product is also not clearly understood and hence leeway is estimates in this regards require consideration.
The above have been considered through the prudent use of tools highlighted below.
Based on the response that the new product gathers from the market, there can be essentially following two scenarios besides the base case already defined.
The probability of occurrence of this scenario has been pegged at 25%. The assumptions for this particular case are outlined as follows.
- Owing to overwhelming response to the product which surpasses the consultants expectations, the growth rate is revised to 70% for the second and third year of the project.
- The decrease in sales is also revised to 40% for the fourth and fifth year.
- No change in discount rate
The NPV under the above assumptions is $11.77 million.
The probability of occurrence of this scenario has been pegged at 35%. The assumptions for this particular case are outlined as follows.
- Owing to underwhelming response to the product which fails to level upto the consultants expectations, the growth rate is revised to 30% for the second and third year of the project.
- The decrease in sales is also revised to 60% for the fourth and fifth year.
- The discount rate increases to 15% owing to the increased risk.
The NPV under the above assumptions is -$1.37 million.
Net NPV expected = 0.25*11.77 + 0.4*5.6 + 0.35*(-1.37) = $4.7 million
The NPV fluctuations witnessed on account of change in the discount rate as well as the expected growth rate in sales are summarised below.
The key observation is that while NPV seems sensitive to movements in the variables highlighted above, it seems quite unlikely that a negative NPV would result from the project unless the deviation from base scenario is quite high which would have low associated probability (Northington, 2015).
Taking into consideration the summary of the financial analysis carried out above, the recommended course of action would be to go ahead with the proposed project as it would prove to be EPS accretive for shareholders as apparent from the analysis of the base case along with uncertainty analysis which indicate high possibility of the project being in the interest of the shareholders (Petty et. al., 2015).
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Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.
Northington, S. (2015) Finance, 4th ed. New York: Ferguson
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015). Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French Forest Australia.