Sensitivity analysis is the most commonly used type of risk analysis, and scenario analysis is helpful for assigning probabilities to different scenarios. This project provides you with an opportunity to use these types of risk analysis to make decisions on a given project.

Start with the partial model in the file Ch11 P18 Build a Model.xlsx on the textbook's companion website.

Webmasters.com has developed a powerful new server that would be used for corporations' Internet activities. It would cost $10 million at Year 0 to buy the equipment necessary to manufacture the server. The project would require net working capital at the beginning of each year in an amount equal to 10% of the year's projected sales; for example, NWC0 10% Sales1. The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 3%. The company's non-variable costs would be $1 million in Year 1 and would increase with inflation.

The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. Also, the project's returns are expected to be highly correlated with returns on the firm's other assets. The firm believes it could sell 1,000 units per year. The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of the equipment at the end of the project's 4-year life is $500,000. Webmasters.com's federal-plus-state tax rate is 40%. Its cost of capital is 10% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 and 1.2. Low- risk projects are evaluated with an 8% project cost of capital and high-risk projects at 13%.

Based on the above project information, conduct the following analyses and recommend if this project should be accepted or not:

Using Excel, estimate free cash flows and calculate NPV and IRR. Using Excel, conduct a sensitivity analysis to determine the sensitivity of NPV to the changes in the unit sales, WACC, variable costs, sales price and non-variable costs - changing one variable at a time, holding other things constant. Set these variables' values at 10% and 20% above and below their base-case values. Using Excel, conduct a scenario analysis to evaluate the risk of the project. Assume that there is a 25% probability that best-case conditions, with each of the variables (the unit sales, WACC, variable costs, sales price and non-variable costs ) discussed in question (b) being 20% better than its base-case value, will occur. There is a 25% probability of worst-case conditions, with the variables 20% worse than the base, and a 50% probability of base-case conditions. Once you create scenario summary, find expected NPV, a standard deviation of NPV and coefficient of variation using the scenario summary table.

If the project appears to be more or less risky than an average project, find its risk-adjusted NPV. Based on your analysis, should you accept the project?