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ANALYSIS OF THE PROFITABILITY VS CASHFLOW OF THE PROJECT Abdullah was delighted when he received Muhammad's calculation results and the WACC estimate. He thought that he had made a good decision in hiring Muhammad. For further analysis, Abdullah and Muhammad had the following conversation regarding how they should evaluate thepotential profitability of the project Muhammad: With the sales and cost estimates, I have obtained from the marketing and accountingdepartments in Exhibit 2, we should be able to estimate the project's cash flows for the four-year horizon. Abdullah: Excellent! Since we are in the beverage business, all our sales are in cash, and we settle all the expenses in the month incurred How are we going to evaluate the project's profitability to determine if it is feasible? Muhammad: The Net Present Value (NPV) and Internal Rate of Retum (IRR) methods are generallyused to evaluate project. The financial goal of a fimi is to maximize market value. The NPV of a project shows its contribution to the market value of the fimm. Abdullah: Correct! However, the NPV is a dollar amount. It is difficult to explain the profitability of a project as a dollar amount to the company'sshareholders. It is easier to compare the project's IRR with the firm's WACC to convince the shareholders that we can eam a higher percentage retum on the investment than what it would cost to finance it. Muhammad Currently, our company's WACC is around 10%. It is inappropriate to use the WACC as the rate of return for a stand alone project like this. It needs to have its owed required rate of return to cover the allocated cost imposed later on. Abdullah Wow! Great understanding Since our coffee shop is the place for people to hang out we need a higher retum for every investment we make as it also needs to cover the customers' time spent. Our policy is that any additional investment tothe existing premise shall have a 200% return. I would also like to see the NPV, RR, and discounted payback period results for the project. Muhammad. Consider it done! With the instructions hereceived from Abdullah, Muhammad immediately started to work on the cash flow calculations using the data in Exhibit 2 to analyze the project's profitabilitywith the NPV, IRR and discounted payback period methods. Exhibit 2: The data Muhammad plans to use in the calculation of the cash flows for the project and in the evaluation of its profitability RM The Machinery s Invoice Price Shipping Charges Installation Cost Depreciable Basis 56,000 1,000 3.000 60.000 Depreciation Rates: Straight-line method at 25% per year Salvage Value: RM8.000 Anmal revenue and cost estimares (assume 3% inflation rate): Yearl Year 2 Year 3 Units B0.000 30,000 30.000 Unit Price (RM) 12 50 Unit Cost 6.10 Year 30.000 RM Year 2 30,000 Year 3 30,000 Year 4 30,000 Yearl 30,000 12.50 6.50 Units Unit Price (RM) Unit Cost Sales Costs RM 375,000 225,000 1 This exhibit shows the data needed to calculate the cash flows for this project . The new production system has a useful life of 4 years, with a salvage value of RM8,000. The expresso coffee maker is expected to generate 30,000 cups of sales per year, with a unit selling price of RM12.50 and a unit cost of RM6.50 RISK AND SENSITIVITY ANALYSIS After Muhammad submitted the cash flow calculations and the project profitability analysis results to Abdullah they had the following conversation regarding the risk analysis for the project. Page 5 of 6 ACFM613 Semester 1, 2021 2022 a Abdullah: The NPV, IRR and discounted payback results are quite promising. However, we should also conduct a sensitivity analysis of the project before we go ahead with it. Since the new products are in-line with our nature of business, I do not believe the new project will change its beta and its overall market risk. Therefore, it should be sufficient to evaluate the stand-alonerisk of the project. What are the techniques that we can use to assess the stand-alone risk of a project? Muhammad: Sensitivity analysis is a widely used technique to determine how much a project's NPV will change in response to a given change in an input variable. Input variables such as sales or the cost of capital are often used while holding other things constant. Abdullah Sales figures are difficult to forecast with a high degree of accuracy. Therefore, we should conduct a sensitivity analysis concerning possible changes in the forecasted sales figu It should be sufficient to evaluate the impact of an increase or a decrease of 20% in sales from our base forecast. Our base sales forecast that the new expresso coffee maker will employ at about 70% capacity. Therefore, the unutilized capacity of the system should enable us to accommodate a 20 increase in sales. We can assume that the fixed coat will not change with the 20% increase or decrease in sales. Muhammad: No problem. We can conduct a sensitivity analysis for the project's NPV regarding a 20% deviation from our base sales forecast. We will use scenario analysis. In this technique, the best and worst-case NPV scenarios are compared with the project's expected NPV. Do you want us to conduct a scenario analysis of the project? Abdullah Yes. It would be a.good idea As the best-case scenario, assume that the sales forecast will be 20% higher and for the worst-case scenario, assume that the sales forecast will be 20% lower. The expected retum of the project is to remain at 200% Muhammad. No problem. I should be able to submit the risk analysis results to you this a ftemoon With the instructions he received from Abdullah, Muhammad immediately started to conduct the sensitivity analysis using scenario analysis techniques