Financial Analysis

1 | 2 | 3 | 4 | 5 | 6 | 7 | |

Year | PV of $ 1 at 16% | Optimistic cash flow | Present value
(1) x (2) |
Expected cash flow
(2+6)/2 |
Present value
(1) x (4) |
Pessimistic cash flow | Present value
(1) x (6)) |

1 | 0.8621 | 1, 800,000 | 1,551,780 | 1,400,000 | 1,206,940 | 1,000,000 | 862,100 |

2 | 0.7432 | 3,800,000 | 2,824,160 | 2,600,000 | 1,932,320 | 1,400,000 | 1,040,480 |

3 | 0.6407 | 5,200,000 | 3,331,640 | 3,200,000 | 2,050,240 | 1,200,000 | 768,840 |

4 | 0.5523 | 8,200,000 | 4,528,860 | 4,600,000 | 2,540,580 | 1,000,000 | 552,300 |

5 | 0.4761 | 10,200,000 | 4,856,220 | 5,400,000 | 2,570,940 | 600,000 | 285660 |

Total | 17,092,660 | 10,301,020 | 3,509,380 | ||||

In the scenario analysis, several variables are varied concurrently. The most common scenarios are presented for the case, which include the expected (normal), optimistic scenario, and the pessimistic scenario (Prasanna, 2011, Presanna, 2009). In the normal scenario, business operations are expected to assume their normal trends. In the optimistic case, all variables are assumed to take on optimistic values. On the pessimistic scenario, variables take pessimistic values (Presanna 2011). In the presented case, to achieve a rate of return of 16%, the net present value at that rate should be positive (Smart and Graham, 2011, Presanna, 2009). The net present value for the three scenarios (optimistic expected, and pessimistic) are shown above. As can be seen from the above calculations, the expected cash flow is an average of optimistic and pessimistic cash flows. LaGrande confirms this because they predict that the most likely results are halfway between the optimistic and pessimistic predictions. The cash flows are therefore discounted at the rate of 16% as indicated above.

The investment and salvage values are calculated below. These two have no relationships to the optimistic and pessimistic assumptions.

Investment= (1.0000 x $7,000,000) $ 7,000,000,

Salvage value of the facilities = (.4761 x $800,000) $ 380,880

Salvage value of the working capital= (.4761 x $1,500,000) $ 714,150

Total= 8,095,030

The investment of $7,000,000 is composed of $3,000,000 for the production facilities, $2,500,000 for advertising, and $1,500,000 for working capital. The salvage value at the end of the 5 years will be an inflow for the company. Therefore, the PV is calculated and subtracted 9Heisinger, 2009). In addition, the working capital will be recovered at the end of the project. Therefore, the PV is calculated and subtracted from the initial investment. These are calculated as follows;

Optimistic ($17,092,660-$8,095,030) =$6,385,770

Expected ($10,301,020-$8,095,030) =$2, 205,990

Pessimistic (3,509,380-$8,095,030) = -$4,585,650

From these calculations, it is clear the product has a positive present value. Therefore, the company should go ahead and launch the product.

If the contribution margin is 58% instead of 50%, then the NPV for the three scenarios will be as follows;

Optimistic ($17,092,660 X58/50 -$8,095,030) =$11, 732,456

Expected ($10,301,020 X58/50 -$8,095,030) =$11, 949, 183

Pessimistic (3,509,380 X58/50 -$8,095,030) = -$4,024,149

The contribution is 42% instead of 50%, the NPV for the three scenarios will be as follows;

Optimistic ($17,092,660 X42/50 -$8,095,030) =$6, 262,804

Expected ($10,301,020 X42/50 -$8,095,030) =$55,826

Pessimistic (3,509,380 X42/50 -$8,095,030) = -$5, 147150

The NPV for the optimistic and expected scenarios is positive. The pessimistic results are negative. Therefore, the project should be undertaken as the expected NPV is positive.

References

Heisinger, K. (2009).*Essentials of Managerial Accounting*. London: engage Learning.

Presanna, C (2009).*Projects 7/E.* New Delhi: Tata McGraw-Hill Education

Presanna, C (2011). *Financial Management.* New Delhi: Tata McGraw-Hill Education

Smart, B. S. and Graham, R. J. (2011). *Introduction to Corporate Finance: what companies do*. London:Cengage Learning.

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