The probability of Project X achieving cash flows with a UP greater than $8949. 47 is probably closer to 30% than 90%. Similarly, the probability of Project Y achieving cash flows with a UP greater than $11,933. 62 is probably closer to 45% than 70%. 4 d. Project Y is more risky (larger range of possible outcomes) and has a higher attention NP. Project X has less risk and less return while Project Y has more risk and more return, thus the risk-return trade-off. (NOTE: as the projects have different risk levels, i.
Project Y obviously has a wider range of possible outcomes around the expected outcome, the project cash flows should actually be discounted at different discount rates to reflect the difference in risk. The discount rate for Y should be higher than the rate used for X. This will affect the relative Nips. ) 5 Which project appears to be better in terms of minimizing losses depends on the numbers you use. Using numbers directly out of the table, you would select Project X, with a 60% chance of achieving cash flows in the desired range and a 90% chance of achieving cash flows in the desired range or better.
However, making risk adjustments through Radar caused the ranking to reverse from the non-risk adjusted results. The final choice would be to select Plan X since it ranks first using the risk-adjusted method. 4. Plan X Value of real options = 0. 25 x $100,000 $25,000 Investigative Invalidation + Value of real options Investigative = $261,040 + $25,000 = $286,040 Plan Y Value of real options = 0. 20 x $500,000 = $100,000 Investigative = Invalidation + Value of real options Investigative = $225,800 + $100,000 = $325,800 5. The addition of the value added by the existence of real options reverses the ordering of the projects.
Project Y is now favored over project X using the strategic RADAR NP. Capital rationing could change the selection of the plan. Since Plan Y requires only $2, 100,000 and Plan X requires $2,700,000, if the firm’s capital budget was less than the amount needed to invest in project X (the project preferred under part 2), the firm would be forced to take Y to maximize shareholders’ wealth subject to the budget constraint. 6. 11 2. BEE Chapter 6 Problem 15. The NP using the most likely estimates is $8,954,606. 06. See excel spreadsheet “Chi Problem 15” for further details.
Sensitivity analysis of the plant to manufacture a motorized golf buggy for Ride Ltd Variable Most Optimistic keel estimate estimate Pessimistic estimate NP optimistic estimate ($’sass) 10 425. 431 NP pessimistic estimate ($’sass) 7483. 78 Range of the NP ($’sass) 2941. 651 Sales (units) (COCO’S) Selling price ($shoos) 3. 5 4. 0 3. 0 0. 8 0. 85 0. 75 9617. 993 8291. 218 1326. 775 Fixed operating costs ($’sass pa) 90 80 100 8 992. 514 8916. 598 75. 916 Variable operating costs 0. 024 0. 023 ($’sass pa) per unit per unit Life of the plant (years) 0. 025 per unit 8 967. 874 8941 . 338 26. 536 10 436. 14 7324. 066 3112. 848 Judging by the range of the net present value, the most sensitive variables are he life of the plant and changes (or errors) in sales, both units sold and selling price. It should be noted that for all pessimistic estimates the NP remains positive. 12 In additional analysis, even where a “worst case scenario” is considered with all variables set to their pessimistic value, the NP remains positive. This knowledge would make the financial manager reasonably confident that accepting the project would be a good decision financially. 13 3. This question was in the 2005 exam.
The project should continue if the NP of incremental cash flows is greater than zero. Using the analysis as presented: Using the most likely cash flows, the project should continue as NP is positive. The scenarios where NP becomes negative is when market share is 6%, and the worst case scenario, ii. When the worst case is achieved for all variables. It appears that the project’s NP is most sensitive to market share, so possibly more research should be done on this Issue. However, there are two of problems with the current analysis: The cash flows incorporate development costs, which are sunk costs.
Without these all Nap’s are positive, so it appears that the project should go ahead. The initial analysis is performed on “Most Likely”, rather than “Expected” cash flows. Probabilities of different outcomes are required so that the analysis can be undertaken 14 using expected cash flows (where the expected cash flow is the weighted average of the range of possible cash flows). Probabilities would also be useful to assess the likelihood of the best and worst case scenarios occurring. Further information required should include: Given that the drug approval body is notoriously slow; what is the NP if approval is delayed 1 or 2 years?
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