3.1.

SCENARIO ANALYSIS Family Security is considering the introduction of a child

security product consisting of tiny Global Positioning System CGPS) trackers that can be
inserted in the sale of a child's shoe. The trackers allow parents to track the child if he or she
were ever lost or abducted. The estimates, plus or minus 10%, associated with this new
product are as follows:

Unit price: $125

Variable costs per unit: $75

Fixed costs: $250,000 per year

Expected sales: 10,000 per year

Because this is a new product line, the firm's analysts are not confident in their estimates and
would like to know how well the investment would fare if the estimates on the items listed
above are 10% higher or 10% lower than expected. Assume that this new product line will
require an initial outlay of $1 million, with no working capital investment, and will last for
ten years, being depreciated down to zero using straight-line depreciation. In addition, the
firm's management uses a discount rate of 10% and a 34% tax rate in its project analyses.

a. Calculate the project's NPV under each of the following sets of assumptions: (1) the best-
case scenario (use the high estimates – unit price 10% above expected, variable costs 10%
less than expected, fixed costs 10% less than expected, and unit sales 10% higher than
expected), (2) the base case using expected values, and (3) the worst-¬case scenario.

b. Given your estimates of the range of NPVs for the investment, what is your assessment of
the investment’s potential?

c. What are the limitations of this type of scenario analysis? (Hint: What are the chances that
all variables will deviate from their expected values in a best- or worst-case scenario?)

3.2 BREAKEVEN SENSITIVITY ANALYSIS The expected annual free cash flow for the
GPS investment from Problem 3-1 is computed as follows:

Revenues $1,250,000
Variable cost 750,000
Fixed expenses 250,000
Gross profit $ 250,000
Depreciation 100,000
Net operating income $ 150,000
Income tax expense 51,000
 NOPAT $ 99,000
Plus: depreciation 100,000
Less: CAPEX -
Less: working capital investment -
Free cash flow $ 199,000

Construct a spreadsheet model to compute free cash flow that relies on the following
estimates:

Base Case Estimates Values

Initial cost of equipment $1,000,000.00
Project and equipment life 10 years
Salvage value of equipment $0
Working capital requirement $0
Depreciation method Straight-line
Depreciation expense $100,000.00
Discount rate 10.00%
Tax rate 34.00%
Unit sales 10,000
Price per unit $125.00
Variable cost per unit $75.00
Fixed costs $250,000.00

What Level of annual unit sales does it take for the investment to achieve a zero NPV?
Use your spreadsheet model to answer this question. (Hint: Use the Goal function in Excel.)
If unit sales were 15% higher than the base case, what unit price would it take for investment
to achieve a zero NPV?

3.4. BREAKEVEN SENSITIVITY ANALYSIS The Clayton Manufacturing Company is

considering an investment in a new automated inventory system for its warehouse that will
provide cash savings to the firm over the next five years. The firm’s CFO anticipates
additional earnings before interest, taxes, depreciation, and amortization (EBITDA) from cost
savings equal to $200,000 for the first year of operation of the center; over the next four
years, the firm estimates that this amount will grow at a rate of 5% per year. The system will
require an initial investment of $800,000 that will be depreciated over a five-year period
using straight-line depreciation of $160,000 per year and a zero estimated salvage value.

a. Calculate the project’s annual free cash flow (FCF) for each of the next five years, where
the firm’s tax rate is 35%.

b. If the cost of capital for the project is 12%, what is the projected NPV for the investment?
3.6. PROJECT RISK ANALYSIS—COMPREHENSIVE Bridgeway Pharmaceuticals
manufactures and sells generic over-the-counter medications in plants located throughout the
Western Hemisphere. One of its plants is trying to decide whether to automate a portion of its
pack- aging process by purchasing an automated waste disposal and recycling machine. The
proposed investment is $400,000 to purchase the necessary equipment and get it into place.
The machine will have a five-year anticipated life and will be depreciated at a rate of $80,000
per year, toward a zero anticipated salvage value. The firm’s analysts estimate that the
purchase of the new waste-handling system will bring annual cost savings of $40,000 from
reduced labor costs, $18,000 per year from reduced waste disposal costs, and $200,000 per
year from the sale of reclaimed plastic waste net of selling expenses. Bridgeway requires a
20% return from capital investments and faces a 35% tax rate.

a. Using the estimates provided above, should Bridgeway purchase the new automated waste-
handling system?

b. The manager at the plant where the handling system is being contemplated has raised some
questions regarding the potential savings from the system. He asked the financial analyst in
charge of preparing the proposal to evaluate the impact of variations in the price of plastic
waste materials, which have proven to be volatile in the past. Specifically, what would be the
impact of price reductions for the waste that drive the revenues from the sale of waste down
to half their estimated amounts in Years 1 through 5?