There has been a proposal on the part of the company to launch a new product as the current product offering of the company is witnessing high competition on declining cost concerns. The significance of this memo needs to be understood in this backdrop since this memo highlights the analysis of the proposed project using various tools and techniques so as to comment on the underlying financial feasibility. The key information about the project expected cash flow has been taken into consideration to derive the incremental post tax cash flows which form the basis for further analysis. Besides, considering the risky nature of the project and uncertainty with regards to consumer response, uncertainty analysis has also been performed. This highlights the financial robustness of the project under adverse input conditions. With regards to computation of project cash flows the following aspects have been considered.
- Since various capital budgeting measures are based on discounted cash flows, hence there is a need to compute the present value of the future cash flows arising from the project. In reality, these cash flows for a given year would arise at different times. But to make the computation simpler, it is assumed that all project related cash flows tend to take place at project life end (Petty et. al., 2015).
- The company that as per the proposed project details would serve as the manufacturing base is currently being used by outside party and the company realises rental income annually to the extent of $ 250,000. If the company does decide to go ahead with the project, then one incremental cash outflow would be the reduction of rental income which ought to be considered as an operational expense for the project since now the same rent has to be paid for factory use considering arm length transaction (Damodaran, 2015).
- Also, considering a new product line, hence the company has taken the services of a external consultant but the fees given to him/her would not be part of the incremental cash flows. This is because it is a sunk cost for this project since without regards to the decision taken, the fee cannot be obtained back from the consultant (Brealey, Myers and Allen, 2014).
Alter tax Project Cash Flows
The cash flows arising from the proposed project are listed as follows in a tabular format.
In relation of the cash flow in base case, the financial feasibility can be ascertained using capital budgeting tools. The result of the computation of these parameters as indicated in the attached spreadsheet is shared below along with the decision in relation to the given project.
The project has successfully demonstrated financial feasibility in the base case but owing to the risk involved in the project, it is essential to analyse the underlying change in NPV when the key input variable display unfavourable movement. Two variables that would be considered in this analysis are as follows.
- Project discount rate – This has been selected owing to risk of project being higher than the usual projects which puts an upward pressure on the discount rate adversely impacting project feasibility.
- Growth rate of unit sales – The company is launching a new product and despite the prediction by external consultant there is risk with regards to the response received by customers.
The following two techniques have been used.
The two possible scenarios along with their underlying assumptions are explained below.
Estimates probability of this scenario = 0.25
The key assumptions include unit growth rate at 70%, 60%, -40%, -40% for year 2, 3, 4,5 respectively.
Computed NPV by making the above changes as highlighted in the attached spreadsheet comes out as $10.70 million
Estimates probability of this scenario = 0.35
The key assumptions include unit growth rate at 35%, 25%, -60%, -70% for year 2, 3, 4,5 respectively. Also, there is hike in discount rate to 13.5%.
Computed NPV by making the above changes as highlighted in the attached spreadsheet comes out as -$0.79 million
Expected NPV computation = 0.25*10.70 + 0.4*5.6 + 0.35*(-0.79) = $4.64 million
The NPV movement as the above two variables i.e. discount rate and the unit volume growth in year 2 and year 23 continue to change is captured in the graph shown below.
From the above graph, there is immense resilience in the NPV which does get impacted by the variables chosen. However, for the NPV to become negative the adverse movement in these variables has to be sizable and the corresponding likelihood of this happening is quite remote thus implying that the project is robust enough to stay NPV position even under possible adverse circumstances (Petty et. al, 2015).
The financial analysis clearly signifies that the proposed project is feasible on the financial front and this is not only limited to the base case but also successfully would accommodate possible adverse movements in key variables. Therefore, it is in the shareholders’ interest that project implementation must commence at the earliest and during implementation, the various changes in the input variables used in the financial model must be reflected so that possible adjustments can be made if required (Parrino and Kidwell, 2014).
Brealey, R. A., Myers, S. C., & Allen, F. (2014) Principles of corporate finance, 2nd ed. New York: McGraw-Hill Inc.
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.
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.