Financial Strategy and Governance: NPV Analysis and Sensitivity

This report conducts a Net Present Value (NPV) analysis of a project, considering incremental cash flows, fixed costs, depreciation, and sales revenue over a 10-year period. The analysis includes a sensitivity analysis to changes in the discount rate, revealing the project's robustness to financing costs. T...Read More

FINANCIAL STRATEGY AND GOVERNANCE
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Introduction
Prudent capital allocation is one of the key requisite for generation of shareholders’ value.
This is enabled through the application of appropriate capital budgeting techniques which
allow the management to decide whether a project is financially viable or not. However, the
focus should not be limited to only the quantitative aspects as qualitative aspects must also be
considered before taking capital allocation decisions. In this background, the objective of this
report is to carry out an NPV analysis of the project coupled with highlighting the sensitivity
of the project to changes in discount rate. This would allow the management to decide
whether incremental capital should be allocated to the given project or not.
Analysis of the project
NPV Analysis
A key requisite in order to apply the capital budgeting techniques is to estimate the
incremental cash flows from the project. The following key observations can be made with
regards to the given project.
1) The $10 million expense on factory building is a sunk cost for the purposes of this project.
This is because it has already been incurred three years ago and would not be recovered or
incurred owing to the decision taken with regards to project (Damodaran, 2015).
2) The depreciation related to the factory would not be considered as this is not incremental
and any tax shield on account of the same would not be considered. Similar treatment
would be givne to the cost of dismantling the factory. This is because the factory would
otherwise also have to be dismantled once the project is over and is not contingent to the
given project. Also, the cost of dismantling remains the same and hence no incremental
dismantling costs have to be incurred by the company (Parrino and Kidwell, 2014).
3) The expected fixed cost that would need to be incurred for production to commence is $ 8
million.
4) Incremental depreciation is available with regards to the above fixed cost which would be
equal to 10% of $ 8 million = $ 0.8 million per year
5) Also, the incremental sales revenue to the extent of $ 2.5 million annually would arise for
10 years starting from today. The variable cost per annum is expected to be $ 0.5 million
per annum.
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Based on the above information and interpretation, the post tax incremental cash flows
expected from the project is indicated as follows.
The NPV needs to be estimated using the discount rate of 10%. The following assumptions
have been made (Brealey, Myers and Allen, 2014).
1) All the relevant cash flows tend to occur at the end of the year only.
2) Further, it has been assumed that the salvage value for the fixed costs which would be
incurred for starting production would be zero at the end of 10 years.
3) Further, the discount rate for the project would remain the same throughout the useful life
of the project.
Taking the above assumptions, the computation of NPV for the given project is shown below.
From the above computation, it is evident that the NPV for the given project is $ 2.08 million.
Considering that the NPV comes out to be greater than zero, hence the given project would
be regarded as financially feasible. Also, this would lead to increase in the wealth of the
shareholders by $ 2.08 million (Beck et. al., 2013).
Sensitivity Analysis
The objective of this analysis is to highlight the sensitivity of thee project to the changes in
discount rate. This is imperative as it highlights the robustness of the project feasibility in
wake of higher financing costs. In order to conduct this analysis, the NPV for various
discount rates need to be determined which is captured in the tabular manner highlighted as
follows (Christensen et. al., 2016).
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The above information can be captured graphically as indicated below.
From the above analysis, it is apparent that NPV of the project is highly sensitive to changes
in discount rate. As a result, any increase in the discount rate beyond 15.3% would imply that
the NPV of the project becomes negative. This would adversely impact the project viability.
As a result, it is imperative to ensure that discount rate remains within a tight control (Petty
et. al., 2016).
Qualitative Factors
It is known that there are competitors that are also working on a similar project. Considering
the innovative nature of the product, it is apparent that the first mover advantage seems
significant. As a result, there is sizable strategic incentive for the company to invest in this
project as it could lead to significant future profitability especially considering that early
results for the product have been encouraging (Damodaran, 2015). Also, the company has
made significant investment in building the factory and hence efforts should be made to
ensure that the project reaches the logical conclusion. Thus, it can be concluded that the given
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project seems significant from the strategic perspective as well and hence it makes sense that
the company goes ahead with the project.
Conclusion & Recommendation
The given project has been analysed from both qualitative and quantitative perspective in the
light of the available information. For quantitative analysis, NPV has been computed by
deriving the expected incremental post tax cash flows associated with the project. This has
come out to be positive which implies that the project is economically feasible. Further, from
a strategic perspective also, the project seems significant as any delay in commencing
production would mean that other players might launch their product in market leading to
significant loss to the company. As a result, the given project should be commenced at the
earliest as it would create wealth for shareholders besides providing a competitive advantage.
However, a key issue with the project is that it is highly sensitive to changes in the discount
rate. As a result, it is recommended that the company should keep a strict control of the
discount rate.
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References
Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V. and Finch, N. (2013) Fundamentals
of corporate finance, London: Pearson Higher Education, pp. 78-80
Brealey, R. A., Myers, S. C. and Allen, F. (2014) Principles of corporate finance, 2nd ed.
New York: McGraw-Hill Inc, pp. 101-102
Christensen, M, Drew, M, Blanchi, R .and Ross, S. (2016), Fundamentals of Corporate
Finance, 6th ed., New York: McGraw Hill, pp.123
Damodaran, A. (2015), Applied corporate finance: A user’s manual, 3rd ed., New
York:Wiley, John & Sons, pp. 65-66
Parrino, R. and Kidwell, D. (2014) ,Fundamentals of Corporate Finance,4th ed., London:
Wiley Publications, pp. 76
Petty, JW, Titman, S, Keown, A, Martin, JD, Martin, P, Burrow, M & Nguyen, H (2016),
Financial Management, Principles and Applications, 3rd ed., Sydney: Pearson Education &
French Forest Australia, pp. 88-89
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