Case "What If Analysis"

The best experience about the ABC Corp. was how to come up with Useful and innovative products in the midst of economic adversity. Due to severe price competition, the revenues and profitability was badly affected. The designer of the products have immense pressure to come up something new as a useful product to be sold. Finally, they came up with an innovation to introduce remote control dish washer.

Consultation with retailers and customers, indicated that demand of this item would be excellent, provided the price was lower than the regular machine. The testing and development phases took almost $3$ years and the final product passed all safety requirements.

Before being given the go ahead to go into full capacity production of the machine, the designed team had to present a detailed financial plan to the capital investment committee CIC which was chaired by the VP of Finance department, Mr$.$ Abid Majeed. The proposal had to include detailed cost and revenue estimates with ample documentation to support the numbers,

Having a vast experience of these kinds of proposals before, the head of designed team, Sarfraz Ahmed knew that he had better take every possible factor into account and be prepared for a rigorous questions in front of committee members. Fortunately for Sarfraz, his assistant Umar who had recently earned his CFA designation, was an experienced and dependable employee. Both were very keen to come up with the best recommendations supported by the financial plan.

So the Sarfraz and Abid Majeed began collecting the necessary information. They knew that to have a comprehensive feasibility study they would have to include the following:

$1.$ Pro forma statements showing expected annual revenues, variable costs, and net cash flows over the economic life of the project with appropriate supporting documents;

$2.$ Break Even Analysis;

$3.$ Sensitivity of the cash flows to alternative scenarios of sales growth and profit margins:

Based on the data provided by the marketing department, they prepared Table $1,$ showing the expected unit sales of the machine over its $10$ years economic life and the expected selling price per unit. Note that the price of Rs$\mathrm{.}1000$ per unit was estimated to gradually drop to Rs$\mathrm{.}900$ per unit over the $10-$year period reflecting competitive pressures. Depreciation for this project was based on the $7-$year MACRS rates as shown in Table $2.$ The cost of equipment, including shipping, handling, and installation was estimated at $20$ million. It was estimated that after $10$ years, the equipment and tools could be sold for $4$ million.

The production would be done in an unused plant of the firm. Similar plant locations could be leased for

Rs$\mathrm{.}10,000$ per month. Fixed costs were estimated to be Rs$\mathrm{.}1,500,000$ per year while variable production

costs per unit were expected to be Rs$\mathrm{.}400.$ To get the project underway, additional inventory of $500,000$

would be required. The company would increase its accounts payable by $600,000$ and its accounts

receivable by $1,000,000.$ Sarfraz and Abid estimated that each year thereafter, the net working capital of

the firm would amount to $5\%$ of sales. The weighted average cost of capital was calculated to be $14\%,$

Table $1$

Projected Unit Sales and Price

Unit Sales

Year

$2$

Unit Price

$$1000$

$1000$

$1000$

$950$

$3$

$4$

$5$

$30,000$

$34,000$

$38,800$

$38,000$

$36\mathrm{.}900$

$1$ of $3$

$30,000$

$35,500$

$35,000$

$34,500$

$950$

$6$

$950$

$950$

$7$

$8$

$900$

$9$

$900$

Table $2$

Modified ACRS Depreciation Allowances

$3-$Year

$33\mathrm{.}33\%$

Year

$1$

$2$

$3$

$4$

$5$

$6$

$7$

$8$

$5-$Year

$20\mathrm{.}00\%$

$7-$Year

$14\mathrm{.}29\%$

$44\mathrm{.}44$

$32\mathrm{.}00$

$24\mathrm{.}49$

$14\mathrm{.}82$

$7\mathrm{.}41$

$19\mathrm{.}20$

$17\mathrm{.}49$

$11\mathrm{.}52$

$12\mathrm{.}49$

$11\mathrm{.}52$

$5\mathrm{.}76$

$8\mathrm{.}93$

$8\mathrm{.}93$

$8\mathrm{.}93$

$4\mathrm{.}45$

Questions:

$1.$ Need to prepare pro forma Income statement with the help of given cash flows.

$2.$ Conduct Scenario analysis by $15\%$ plus and minus change.

$3.$ Suitable calculations to realize the vulnerability of different variables in sensitivity analysis.

$4.$ How should the annual interest expenses of Rs$.400,000$ be treated? Explain

$5.$ Using the base case estimates calculate the cash, accounting, and financial breakeven.

$6.$ If the company has spent $500,000$ in developing the prototype of the machine. How both of them treat this item in their report.

$7.$ Calculate the IRR of this project