Seminar in Finance:

Can you please help me figure out how to do the Sensitivity and Scenario analysis? Greatly appreciated!

sensitivity analysis:

Scenario Analysis:

Case - Canyon Buff's Chemical Equipment This case is a simple capital budgeting exercise that should reinforce your understanding of the following topics: Incremental unlevered net income Free cash flow Sensitivity analysis and scenario analysis Introduction Canyon Buff Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Canyon Buff is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment. The equipment must be purchased before the chemical production can begin. For tax purposes, the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that the asset can actually be used out into the indefinite future (i.e., the actual useful life is effectively infinite). Canyon Buff anticipates that the sales will be $30,000,000 in the first year (Year 1). They expect that sales will initially grow at an annual rate of 6% until the end of sixth year. After that, the sales will grow at the estimated 2% annual rate of inflation in perpetuity. The cost of goods sold is estimated to be 72% of sales. The accounting department also estimates that at introduction in Year 0, the new product's required initial net working capital will be $6,000,000. In future years accounts receivable are expected to be 15% of the next year sales, inventory is expected to be 20% of the next year's cost of goods sold and accounts payable are expected to be 15% of the next year's cost of goods sold. The selling, general and administrative expense is estimated to be $6,000,000 per year, but $1 million of this amount is the overhead expense that will be incurred even if the project is not accepted. The market research to support the product was completed last month at a cost of $500,000 to be paid by the end of next year. The annual interest expense tied to the project is $1,000,000. Canyon Buff has a cost of capital of 20% and faces a marginal tax rate of 30% and an average tax rate is 20%. Instructions I posted an incomplete Excel template for your analysis. You need to figure out how to construct the pro forma income statements and calculate the incremental unlevered net income. You should include ONLY the factors that will affect your capital budgeting decision. Revise the template if necessary. Note that your analysis should be set up so the assumptions that impact the cash flow estimates can be easily changed to identify the sensitivity of your calculations to these assumptions. There are three sheets in the template. Use the worksheet NPV for questions 1 to 4, and the other two sheets for questions 5 and 6. To help grade your work, please input the financials and submit your Excel spreadsheet through blackboard (a separate submission link on blackboard). Clearly show your work so that I can trace your numbers. Questions 1. Use Excel to construct six-year pro forma income statements and calculate the incremental unlevered net income for the first six years. 2. Calculate six-year projections for free cash flows. Remember to include cash flows from the income statement and depreciation, changes in net working capital, and capital expenditures or dispositions. Hint: You need to calculate the level of net working capital (NWC) and change in NWC. Pay attention to the timing of NWC. 3. Canyon Buff expects that free cash flow from Year 6 onwards will increase at a constant rate of 2%/year into the indefinite future. Calculate PV(terminal value that captures the value of future free cash flows in Year 6 and beyond). That is, calculate the terminal value first, then find its value in Year 0 (today). Hint: We went over this in Lecture Note 6, so let me briefly review the key points: a. Assuming the cash flows grow at a constant rate g after Year N+1, then Year N TV = (Year N+1 CF)(r-g) (from growing perpetuity formula). where r is discount rate b. We should discount this Terminal Value back to Year 0. 4. Determine the NPV of the project. Remember to net out any initial cash outflows. 5. Perform a sensitivity analysis by varying the four parameters as follows: Initial Assumption Worst Case $30,000 $27,000 Best Case $33,000 6% 0% 10% Parameter Sales in Year 1 NPV Sales Growth through Year 6 NPV Cost of Goods Sold % of Sales) NPV Cost of Capital NPV 72% 77% 67% 20% 23% 17% For example, vary the parameter Sales in Year l" from the worst case $27,000 to the best case $33,000, holding all the other parameters fixed at the level of initial assumptions). Then fill in the highlighted blank boxes for NPV in Excel. Do the same thing for the other three parameters. Suppose you are the financial manager, if you are asked to use limited resources to refine the assumption on ONLY ONE of the above four parameters, which one should you choose and why? Write your answer in Excel. Perform a scenario analysis by simultaneously varying the two parameters below: Sales Growth through Year 6 Scenario 1 (Baseline) 5% Scenario 2 6% Scenario 3 Scenario 4 % Cost of Goods Sold NPV 71% 72% 73% 74% 8% 9% Which scenario generates the highest NPV? Write your answer in Excel. 7 15% 3 Assumptions (Amounts in Thousands Unless otherwise Indicated) 4 Initial Capital Expenditure $9,000 5 Useful Life of Equipment Annual Depreciation $1,800 assume a salvage value of 0 Sales in Year 1 $30,000 8 Sales Growth through Year 6 9 Sales Growth Year 6 Onward 2% 10 Free Cash Flow Year 6 Onward 2% 6.08% 11 Cost of Goods Sold [% of sales) 72% 36.50% 12 Incremental SGUA Expense $5,000 13 Market Research Expense $500 Caveats: 14 Initial Net Working Capital $6,000 0 Must watch the video "Capital Budgeting in-class exercise solution" (in lecture Lecture 6 - Capital Budgeting) first before attempting the case 15 Accounts Receivable Zof Next Yea 15% 1 I have forecast some financials for you. My forecast numbers are highlighted in orange cells. You should have the same numbers as mine. 16 Inventory % of Next Year COGS 20% 2 Use the excel cell reference, NO hard coding. I just copied my forecast numbers, NOT formula. You MUST replace my 17 Accounts Payable % of Next Year C numbers through the use of cell reference. E.g., Year 7 = Year 6'(1+9). To use cell reference, you should type "=H24'B9" in 18 Interest Expense $1,000 cell 124. This is especially important when you do sensitivity analysis and scenario analysis. In these analyses, when you 19 Tax Rate 30% change your assumptions highlighted in blue, e.g. sale in Year 1, you also want your Year 7 sales to automatically change. 20 Cost of Capital 20% 3 Don't forget to fill out the other sheets (sensitivity analysis and scenario analysis) in this file 21 22 Year Year Year Year Year Year Year Year 23 Unlevered Income Statement: 0 1 2 3 4 5 6 7 24 Sales 30,000 31,800 33,708 35,730 37,874 40,147 40,950 41,769 25 Cost of Goods Sold 21,600 22,896 24,270 25,726 27,270 28,906 29,484 30,073 26 Gross Profit 8,400 8,904 9,438 10,005 10,605 11,241 11,466 11,695 27 SG&A Expense 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 28 Depreciation 1,800 1,800 1,800 1,800 1,800 0 0 0 29 30 31 32 EBIT 1,600 2.104 2.638 3.205 3.805 6,241 6.466 33 Income Taxes 480 631 791 961 1,141 1,872 1,940 34 Unlevered Net Income 1,120 1,473 1,847 2,243 2,663 4,369 4,526 35 36 Yorking Capital Calculations 37 Inventory 38 Accounts Receivable 39 Accounts Payable 40 NWC Level 41 Change in NYC 42 CF from Change in NWC 43 4,579 4,770 3,434 5,915 -85 85 4,854 5,056 3,640 6,270 355 -355 5,145 5,360 3,859 6,646 376 -376 5,454 5,681 4,090 7,045 399 -399 5,781 6,022 4,336 7,467 423 -423 5,897 6,142 4,423 7.617 149 -149 6,000 6,000 -6,000 6,015 6,265 4,511 0 -7.617 7,617 1.473 1,800 -355 0 2.918 1.847 1,800 -376 0 3.271 2.243 1,800 -399 0 3,644 2.663 1,800 -423 0 4.041 15,069 4,369 0 -149 0 4.219 4.526 0 7.617 0 12.143 44 Unlevered Cash Flors 45 Unlevered Net Income 1,120 46 Add Back: Depreciation 1.800 47 CF from Change in NWC -6,000 85 48 CF from Capital Expenditure -9,000 0 49 Free Cash Flow -15.000 3,005 50 Year 5 Terminal Value of FCFs in Year 6 and Beyond 51 52 Discount Factor 0.833 53 FCF Present Value -15,000 2,504 54 NPY 2.274 55 in which PV[Year 5 Terminal Value of FCFs 56 in Year 6 and Beyond) 0.694 2,026 0.579 1,893 0.482 1,758 0.402 1,624 0.335 1,413 Worst Case Sales in Year 1 Sales Growth through Year Cost of Goods Sold (% of s. Cost of Capital $27,000 0% 77% 23% Best Case Sales in Year 1 Sales Growth through Year Cost of Goods Sold(% of s. Cost of Capital Copy your baseline projections to this sheet. so that your sensitivity analysis won't alter $33.000 your baseline result in the NPV sheet. 10% 67% 17% Sensitivity Analysis Parameter Initial Assurt Worst L Best Case Sales in Year 1 $30,000 $27,000 $33.000 NPV 2,274 -9,211 13,089 Sales Growth through Year! 6% 0% 107 NPV 137 0 1 Cost of Goods Sold(% of S. 72% 77% 67% NPV 99 0 1 Cost of Capital 20% 23% 17% NPV 6,000 5,400 6,600 Question: Suppose you are the financial manager, if you are asked to use limited resources to refine the assumption on ONLY ONE of the above four parameters, which one should you choose and why? (fill in the blanks highlighted in yellow) Answer: Of the four parameters I would limit cost of capial sold because this calculation is already included in "Sales in year 1". Copy your baseline projections to this sheet, so that your scenario analysis won't alter your baseline result in the NPV Sales Growth % Cost of through Year Goods 6 Sold NPV Scenario 1 5% 71% 2,694 Scenario 2 (Baselin 6% 72% 2,274 Scenario 3 8% 73% 2,568 Scenario 4 9% 74% 2,035 Question: Which scenario generates the highest NPV? (fill in the blanks highlighted in yellow) Answer: Scenario 3 generates the highest NPV. Assumptions (Amounts in $ Thousands Unless otherwise Indicated) Initial Capital Expe $9,000 Useful Life of Equip 5 Annual Depreciatic $1,800 Sales in Year 1 $30,000 Sales Growth throu 6% Sales Growth Year 2% Free Cash Flow Yea 2% Cost of Goods Sold 72% Incremental SG&A $5,000 Market Research E> $500 Initial Net Working $6,000 Accounts Receivabl 15% Inventory % of Nex 20% Accounts Payable 15% Interest Expense $1,000 Tax Rate 30% Cost of Capital 20% Case - Canyon Buff's Chemical Equipment This case is a simple capital budgeting exercise that should reinforce your understanding of the following topics: Incremental unlevered net income Free cash flow Sensitivity analysis and scenario analysis Introduction Canyon Buff Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Canyon Buff is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment. The equipment must be purchased before the chemical production can begin. For tax purposes, the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that the asset can actually be used out into the indefinite future (i.e., the actual useful life is effectively infinite). Canyon Buff anticipates that the sales will be $30,000,000 in the first year (Year 1). They expect that sales will initially grow at an annual rate of 6% until the end of sixth year. After that, the sales will grow at the estimated 2% annual rate of inflation in perpetuity. The cost of goods sold is estimated to be 72% of sales. The accounting department also estimates that at introduction in Year 0, the new product's required initial net working capital will be $6,000,000. In future years accounts receivable are expected to be 15% of the next year sales, inventory is expected to be 20% of the next year's cost of goods sold and accounts payable are expected to be 15% of the next year's cost of goods sold. The selling, general and administrative expense is estimated to be $6,000,000 per year, but $1 million of this amount is the overhead expense that will be incurred even if the project is not accepted. The market research to support the product was completed last month at a cost of $500,000 to be paid by the end of next year. The annual interest expense tied to the project is $1,000,000. Canyon Buff has a cost of capital of 20% and faces a marginal tax rate of 30% and an average tax rate is 20%. Instructions I posted an incomplete Excel template for your analysis. You need to figure out how to construct the pro forma income statements and calculate the incremental unlevered net income. You should include ONLY the factors that will affect your capital budgeting decision. Revise the template if necessary. Note that your analysis should be set up so the assumptions that impact the cash flow estimates can be easily changed to identify the sensitivity of your calculations to these assumptions. There are three sheets in the template. Use the worksheet NPV for questions 1 to 4, and the other two sheets for questions 5 and 6. To help grade your work, please input the financials and submit your Excel spreadsheet through blackboard (a separate submission link on blackboard). Clearly show your work so that I can trace your numbers. Questions 1. Use Excel to construct six-year pro forma income statements and calculate the incremental unlevered net income for the first six years. 2. Calculate six-year projections for free cash flows. Remember to include cash flows from the income statement and depreciation, changes in net working capital, and capital expenditures or dispositions. Hint: You need to calculate the level of net working capital (NWC) and change in NWC. Pay attention to the timing of NWC. 3. Canyon Buff expects that free cash flow from Year 6 onwards will increase at a constant rate of 2%/year into the indefinite future. Calculate PV(terminal value that captures the value of future free cash flows in Year 6 and beyond). That is, calculate the terminal value first, then find its value in Year 0 (today). Hint: We went over this in Lecture Note 6, so let me briefly review the key points: a. Assuming the cash flows grow at a constant rate g after Year N+1, then Year N TV = (Year N+1 CF)(r-g) (from growing perpetuity formula). where r is discount rate b. We should discount this Terminal Value back to Year 0. 4. Determine the NPV of the project. Remember to net out any initial cash outflows. 5. Perform a sensitivity analysis by varying the four parameters as follows: Initial Assumption Worst Case $30,000 $27,000 Best Case $33,000 6% 0% 10% Parameter Sales in Year 1 NPV Sales Growth through Year 6 NPV Cost of Goods Sold % of Sales) NPV Cost of Capital NPV 72% 77% 67% 20% 23% 17% For example, vary the parameter Sales in Year l" from the worst case $27,000 to the best case $33,000, holding all the other parameters fixed at the level of initial assumptions). Then fill in the highlighted blank boxes for NPV in Excel. Do the same thing for the other three parameters. Suppose you are the financial manager, if you are asked to use limited resources to refine the assumption on ONLY ONE of the above four parameters, which one should you choose and why? Write your answer in Excel. Perform a scenario analysis by simultaneously varying the two parameters below: Sales Growth through Year 6 Scenario 1 (Baseline) 5% Scenario 2 6% Scenario 3 Scenario 4 % Cost of Goods Sold NPV 71% 72% 73% 74% 8% 9% Which scenario generates the highest NPV? Write your answer in Excel. 7 15% 3 Assumptions (Amounts in Thousands Unless otherwise Indicated) 4 Initial Capital Expenditure $9,000 5 Useful Life of Equipment Annual Depreciation $1,800 assume a salvage value of 0 Sales in Year 1 $30,000 8 Sales Growth through Year 6 9 Sales Growth Year 6 Onward 2% 10 Free Cash Flow Year 6 Onward 2% 6.08% 11 Cost of Goods Sold [% of sales) 72% 36.50% 12 Incremental SGUA Expense $5,000 13 Market Research Expense $500 Caveats: 14 Initial Net Working Capital $6,000 0 Must watch the video "Capital Budgeting in-class exercise solution" (in lecture Lecture 6 - Capital Budgeting) first before attempting the case 15 Accounts Receivable Zof Next Yea 15% 1 I have forecast some financials for you. My forecast numbers are highlighted in orange cells. You should have the same numbers as mine. 16 Inventory % of Next Year COGS 20% 2 Use the excel cell reference, NO hard coding. I just copied my forecast numbers, NOT formula. You MUST replace my 17 Accounts Payable % of Next Year C numbers through the use of cell reference. E.g., Year 7 = Year 6'(1+9). To use cell reference, you should type "=H24'B9" in 18 Interest Expense $1,000 cell 124. This is especially important when you do sensitivity analysis and scenario analysis. In these analyses, when you 19 Tax Rate 30% change your assumptions highlighted in blue, e.g. sale in Year 1, you also want your Year 7 sales to automatically change. 20 Cost of Capital 20% 3 Don't forget to fill out the other sheets (sensitivity analysis and scenario analysis) in this file 21 22 Year Year Year Year Year Year Year Year 23 Unlevered Income Statement: 0 1 2 3 4 5 6 7 24 Sales 30,000 31,800 33,708 35,730 37,874 40,147 40,950 41,769 25 Cost of Goods Sold 21,600 22,896 24,270 25,726 27,270 28,906 29,484 30,073 26 Gross Profit 8,400 8,904 9,438 10,005 10,605 11,241 11,466 11,695 27 SG&A Expense 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 28 Depreciation 1,800 1,800 1,800 1,800 1,800 0 0 0 29 30 31 32 EBIT 1,600 2.104 2.638 3.205 3.805 6,241 6.466 33 Income Taxes 480 631 791 961 1,141 1,872 1,940 34 Unlevered Net Income 1,120 1,473 1,847 2,243 2,663 4,369 4,526 35 36 Yorking Capital Calculations 37 Inventory 38 Accounts Receivable 39 Accounts Payable 40 NWC Level 41 Change in NYC 42 CF from Change in NWC 43 4,579 4,770 3,434 5,915 -85 85 4,854 5,056 3,640 6,270 355 -355 5,145 5,360 3,859 6,646 376 -376 5,454 5,681 4,090 7,045 399 -399 5,781 6,022 4,336 7,467 423 -423 5,897 6,142 4,423 7.617 149 -149 6,000 6,000 -6,000 6,015 6,265 4,511 0 -7.617 7,617 1.473 1,800 -355 0 2.918 1.847 1,800 -376 0 3.271 2.243 1,800 -399 0 3,644 2.663 1,800 -423 0 4.041 15,069 4,369 0 -149 0 4.219 4.526 0 7.617 0 12.143 44 Unlevered Cash Flors 45 Unlevered Net Income 1,120 46 Add Back: Depreciation 1.800 47 CF from Change in NWC -6,000 85 48 CF from Capital Expenditure -9,000 0 49 Free Cash Flow -15.000 3,005 50 Year 5 Terminal Value of FCFs in Year 6 and Beyond 51 52 Discount Factor 0.833 53 FCF Present Value -15,000 2,504 54 NPY 2.274 55 in which PV[Year 5 Terminal Value of FCFs 56 in Year 6 and Beyond) 0.694 2,026 0.579 1,893 0.482 1,758 0.402 1,624 0.335 1,413 Worst Case Sales in Year 1 Sales Growth through Year Cost of Goods Sold (% of s. Cost of Capital $27,000 0% 77% 23% Best Case Sales in Year 1 Sales Growth through Year Cost of Goods Sold(% of s. Cost of Capital Copy your baseline projections to this sheet. so that your sensitivity analysis won't alter $33.000 your baseline result in the NPV sheet. 10% 67% 17% Sensitivity Analysis Parameter Initial Assurt Worst L Best Case Sales in Year 1 $30,000 $27,000 $33.000 NPV 2,274 -9,211 13,089 Sales Growth through Year! 6% 0% 107 NPV 137 0 1 Cost of Goods Sold(% of S. 72% 77% 67% NPV 99 0 1 Cost of Capital 20% 23% 17% NPV 6,000 5,400 6,600 Question: Suppose you are the financial manager, if you are asked to use limited resources to refine the assumption on ONLY ONE of the above four parameters, which one should you choose and why? (fill in the blanks highlighted in yellow) Answer: Of the four parameters I would limit cost of capial sold because this calculation is already included in "Sales in year 1". Copy your baseline projections to this sheet, so that your scenario analysis won't alter your baseline result in the NPV Sales Growth % Cost of through Year Goods 6 Sold NPV Scenario 1 5% 71% 2,694 Scenario 2 (Baselin 6% 72% 2,274 Scenario 3 8% 73% 2,568 Scenario 4 9% 74% 2,035 Question: Which scenario generates the highest NPV? (fill in the blanks highlighted in yellow) Answer: Scenario 3 generates the highest NPV. Assumptions (Amounts in $ Thousands Unless otherwise Indicated) Initial Capital Expe $9,000 Useful Life of Equip 5 Annual Depreciatic $1,800 Sales in Year 1 $30,000 Sales Growth throu 6% Sales Growth Year 2% Free Cash Flow Yea 2% Cost of Goods Sold 72% Incremental SG&A $5,000 Market Research E> $500 Initial Net Working $6,000 Accounts Receivabl 15% Inventory % of Nex 20% Accounts Payable 15% Interest Expense $1,000 Tax Rate 30% Cost of Capital 20%