Financial Analysis of Options

This memo presents the findings of a financial analysis of two options for the use of recycled plastic sachet. Option 1 involves in-house manufacturing while Option 2 involves outsourcing the manufacturing to an outside vendor. The analysis includes the estimation of incremental cash flows, NPV calculations, and scenario and sensitivity analysis. Based on the analysis, a recommendation is made.

FINANCE
STUDENT ID:
[Pick the date]

MEMORANDUM
To: DuoLever CEO
From: STUDENT NAME
Date: May 15, 2019
Subject: Financial Analysis of options
Dear Sir
The objective of the given memo is to present the findings pertaining to the analysis of the two
options with regards to the use of the recycled plastic sachet. The various benefits of the product
have already been outlined and the company has broadly two options which are outlined below.
1) Option 1: In-house manufacturing
2) Option 2: Outsourcing the manufacturing to an outside vendor
The financial analysis of the two options has been carried out below using suitable budgeting
techniques along with the given inputs.
Option 1 Analysis
The first step with regards to carrying the financial analysis of this option is to estimate the
incremental benefits and costs based on which the incremental cash flows ought to be
determined. The incremental cash flows would then be used to determine the NPV (Net Present
Value) and thereby outline if the option is financially feasible or not. For the given option,
benefits for the company would be derived in two ways.
1) Increased sales forecast by 2% owing to use of recycled packaging
2) Lower energy costs and avoiding supplier margin leading to 15% saving on variable costs
In order to reap the above benefits, the company needs to make an investment of $ 20 million in
plant and equipment which would be depreciated to zero book value over the useful life of the
project i.e. 5 years.
Annual depreciation = (20/5) = $ 4 million

Further, it is noteworthy that additional selling, general & administrative costs would be borne
by the company to the tune of $ 2 million which are project related.
The incremental cash flows expected from this option are summarized below. A key assumption
which has been made is that all the cashflows from the project are realized at the end of the year
only.
It is shown that the WACC for company is 8% and thereby the future cashflows ought to be
discounted at this rate in order to express the incremental cashflows from the project in present
value terms. This is shown as follows.
From the above computation, it is evident that the NPV of this option is positive which would
imply the project is feasible from a financial perspective (Lasher, 2017).
Option 2
As highlighted above, option 2 comprises a scenario where the production is outsourced to an
outside vendor i.e Clean World which would fulfill the requirements of the company for a period
of five years. Under this option, the company would not be able to enjoy the benefits of reduced
variable costs as the same is enjoyed by the manufacturer and thereby the variable costs for the
company would continue to be the same as before. However, incremental benefit owing to

additional sales on account of using the recycled plastic sachet would still continue to exist.
Further, for this particular option the company would not need the initial investment of $ 20
million. Considering the above information, the incremental cash flows expected to be derived
under this scenario are highlighted in the tabular manner indicated as follows.
It is shown that the WACC for company is 8% and thereby the future cashflows ought to be
discounted at this rate in order to express the incremental cashflows from the project in present
value terms. This is shown as follows.
From the base case computations for this option, it is apparent that the given option is financially
feasible as the NPV is positive.
Uncertainty Analysis
Considering that the above analysis for each of the options is essentially based on future
estimates which may alter based on the future scenario. As a result, scenario analysis and
sensitivity analysis have been used as requisite tools to indicate the impact of favorable or
unfavorable changes
Scenario Analysis: Option 1
There are two scenarios considered besides the base scenario. These are outlined below.
 Optimistic Scenario - In this particular scenario, it is estimated that owing to a robust
economy, the future increase in sales without the introduction of the new packaging is

6% p.a. instead of 4% p.a. Also, the higher sales derived on account of the recycled
plastic sachet increased from 2% to 3%. The net impact of these changes is that the NPV
increased to $ 8.52 million.
 Pessimistic Scenario- In this particular scenario, it is estimated that owing to a lackluster
economy, the future increase in sales without the introduction of the new packaging is
2% p.a. instead of 4% p.a. Also, the higher sales derived on account of the recycled
plastic sachet decreased from 2% to 1%. The net impact of these changes is that the NPV
increased to -$ 5.34 million.
Considering that the associated probability of the base case is 50% while that of optimistic and
pessimistic scenarios is 25% each, the expected NPV = 0.5*(1.35) + 0.25*(8.52) + 0.25*(-5.34)
= $ 1.47 million (Petty et. al., 2016).
Sensitivity Analysis: Option 1
The key factor which impacts the NPV is cost of capital and the sensitivity of the NPV of the
base case is measured against changes in cost of capital. The results obtained below clearly
indicate that the NPV is quite sensitive to changes in the cost of capital (Damodaran,2015).
Scenario Analysis: Option 2
For option 2 also scenario analysis has been conducted but even in the pessimistic case the NPV
is $ 3.22 million. The various scenarios have been defined similar to that for Option 1.
Expected NPV = 0.5*(9.90) + 0.25*(17.08) + 0.25*(3.22) = $ 10.03 million
Recommendation

Based on the above discussion, it is apparent that the superior choice is option 2 which involves
outsourcing the production to Clean World. This would result in a higher NPV which implies
greater wealth creation for the shareholders. Also, the risk associated with this option is lesser
considering that option 1 is quite sensitive to cost of capital and may lead to negative NPV in
pessimistic scenario. However, qualitative considerations such as IP rights on technology and
long term strategic considerations are pivotal for final decision making (Brealey, Myers and
Allen, 2014).
Yours Sincerely
STUDENT NAME

References
Brealey, R.A., Myers, S.C. and Allen, F. (2014) Principles of corporate finance. 2nd ed. New
York: McGraw-Hill Inc, pp. 124
Damodaran, A. (2015) Applied corporate finance: A user’s manual. 3rd ed. New York: Wiley,
John & Sons, pp.156
Lasher, W. R., (2017) Practical Financial Management. 5th ed. London: South- Western
College Publisher, pp. 182
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2016)
Financial Management, Principles and Applications. 6th ed. NSW: Pearson Education, French
Forest Australia, pp. 171

Appendix
Option 1
Option 2