Its been four months since you took a position as an assistant financial analyst at CP Berhad. During that time, youve had a promotion and you are now working as a special assistant for capital budgeting, reporting directly to the CEO. Your latest assignment involves the analysis of several risky projects. Because this is your first assignment dealing with risk analysis, you have been asked not only to provide a recommendation on the project in question, but also to respond to a number of questions aimed at judging your understanding of risk analysis and capital budgeting. The memorandum you received outlining your assignment follows:

TO: The Special Assistant for Capital Budgeting

FROM: Mr. V. Morry., CEO, CP Berhad

RE: Capital Budgeting and Risk Analysis

Provide a written response to the following questions:

Explain how sensitivity analysis and scenario analysis are useful tools for evaluating project analysis.

How can break-even analysis be helpful in evaluating project risk?

Now that the management is comfortable with your skills, your boss would like you to look at a new project. This new project involves the purchase of a new plasma cutting tools that can be used in its metal work division. The product manufactured using the new technology are expected to sell for an average price of $300 per unit, and the company analyst performing the analysis expects the firm can sell 200,000 units per year at this price for the period of five years. To get into this business will require the purchase of a $2 million piece of equipment that has a residual or salvage value of $200,000 in five years. In addition, the firm expects to have to invest in additional $300,000 in working capital to support the new business. Other pertinent information concerning the business ventures is as follows:

Initial cost of equipment $2,000,000

Project and equipment life 5 years

Salvage value of equipment $200,000

Working capital requirement $300,000

Depreciation method Straight line method

Discount rate or required rate of return 12%

Tax rate 30%

In addition, the estimates for unit sales, selling price, variable cost per unit, and fixed cash operating expenses for the base-case, worst-case and best-case scenarios are as follows:

	Base-case	Worst-case	Best-case
Unit sales	20,000	15,000	25,000
Price per unit	$300	$250	$330
Variable cost per unit	$200	$210	$180
Annual fixed cost	$500,000	$450,000	$350,000

Estimate the cash flow for the investment under the base-case assumptions. Calculate the project NPV for these cash flows.

Evaluate the NPV of the investment under the worst-case assumptions.

Evaluate the NPV of the investment under the best-case assumptions.