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Question1. Graphically show and explain the following terms, how you could link them to capital budgeting techniques in your decision making.
a. Sensitivity Analysis
b. Scenario Analysis
Question2. Alborz Company manufactures a variety of Lollies. The company is considering introducing a new product (Lolly Choc). The company's manager has been provided with the following information by their business analyst.
-The project has an anticipated economic life of 6 years.
-The Company plans to spend $1,250,000 on advertising campaign to boost sales.
-The Company's interest expense each year will be $425,000.
- The Company is required to purchase a new machine to produce the new product. The machine's initial cost is $6,600,000. The machine will be depreciated on a straight - line basis over 6 years. The Company anticipates that the machine will last for 10 years, the
salvage value after 6 years is $550,000.
- Six months ago the Company also paid $530,000 to a firm to do research regarding new product.
- If the Company goes ahead with the new product, it will have an effect on the Company's net operating capital. The forecasted net working capital will be $250,000 (at time zero)
- The new product is expected to generate sales revenue of $1,250,000, $2,500,000 $3,250,000, $4,500,000, $5,500,000 and $6,000,000 in year 1, 2, 3, 4, 5 and 6 respectively.
Each year the operating cost (not including depreciation) expected to equal 25 percent of sales revenue.
- In addition the Company expects with introduction of new product, sale of other Lollies increase by $500,000 after taxes each year.
- The Company's overall WACC is 7 percent. However, the proposed project is riskier than the average project; the new project's WACC is estimated to be 8 percent.
- The Company's tax rate is 30 percent.
- What is the net present value, internal rate of return, payback period, discounted payback period, and profitability index of the proposed project. Based on your analysis should the project be accepted? Discuss.
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While making a capital budgeting decision, when we decide whether the project is feasible or not we always make assumptions regarding the life of the project, variable cost, selling price, contribution, Incremental fixed cost and discounting rate,while making those assumptions it is clearly visible that all the factors wont remain the same.
There would be a deviation from the assumptions made by us, hence we conduct a sensitivity analysis of each risk factors in unfavourable direction and then see the effect on NPV and IRR, Then upon sufficient analysis we decide whether we should accept the project or not