ACC00716 The Financial Analysis

The company is currently facing high competition in the current business and thereby has decided to launch a new product which can potentially prove to be the future growth engine. However, considering that the new product launch has a higher risk profile in comparison to the current operation, the given memo aims to present the key findings in relation to the financial analysis of the proposed project. The analysis of the project not only considers the base case based on the current estimates but also has considers tools of uncertainty analysis to provide a glimpse of the financial feasibility in case of adverse movements in key input variables. Recommendations at the end of the memo have been offered based on the highlighted analysis that has been undertaken for the project. For estimation of the incremental cash flows, few vital points are highlighted below.

• The production of the new product would be undertaken at the factory currently under the company’s ownership. But, the factory is currently being used by an outside party and thereby the company is able to earn $ 0.25 million as rental income every year. Therefore, it is significant to take note that the usage of the factory would not be free but would cause a decline in the rental income of the company by $ 0.25 million and therefore this is taken as the opportunity cost for factory usage (Petty et. al., 2015).
• Considering that the product to be launched is new, hence the services of an external consultant were used for estimation of the potential sales and also revenue realisation. However, the emolument extended to the consultant does not feature in the incremental project related cash flows owing to this expense recognised as a sunk cost that cannot be altered now irrespective of the fate of the project (Northington, 2015).
• Besides, it has also been assumed that all the cash flows arising on account of the project would be realised only at year end which is critical so that the time value of money concept can be introduced with relative ease (Damodaran, 2015).

Incremental Cash Flows

Considering the cash flows that has been estimated and also the given discount rate of 10% for the project, the computation of the following capital budgeting parameters has been facilitated in the supporting excel.

Based on the above computed values of the key capital budgeting parameters, under the base case, the conclusion can be drawn that on each of the criterion listed above, the given project is acceptable and reflects financial feasibility (Northington, 2015).

Uncertainty Analysis

Considering the project deals with a new product, it is necessary to take into consideration deviations from the base case. One of the unknown input variables is the growth rate of product sale which has been estimated by the consultant but can deviate and has to be considered. Also, considering the higher risk associated with the product, the discount rate also may show deviation on the higher side which ought to be considered.

• Scenario Analysis

The above deviations need to be reflected through two scenarios namely an optimistic scenario and pessimistic scenario.

Optimistic Scenario (Associated probability = 25%)

The key underlying assumptions in this scenario are summarised below.

• The product volume sales are more than expectations and thereby the sales growth estimate for year 2 and year 3 can be enhanced to 75%.
• The incremental demand provides higher pricing leeway to the company which leads to annual product price hike of 4%.

Obtained NPV = $11.57 million

Pessimistic Scenario (Associated probability = 35%)

The key underlying assumptions in this scenario are summarised below.

• The product volume sales are less than expectations and thereby the sales growth estimate for year 2 and year 3 can be reduced to 30%.
• The lower demand provides does not pricing leeway to the company which leads to annual product price hike of 2%.

Obtained NPV = $1.44 million

Expected NPV = 0.25*11.57 + 0.4*5.6 + 0.35*1.44 = $ 5.636 million

• Sensitivity Analysis

Recommendation

In accordance with the financial analysis summary presented, it would be appropriate to recommend the acceptance of the proposed project on the following counts (Petty et. al., 2015).

• For the base case, the various applied capital budgeting tools result in project being accepted from financial feasibility perspective.
• Considering the various scenarios and their respective likelihood, the expected NPV derived exceeds zero on the positive side implying that the project is financially feasible.
• The project robustness and financial feasibility is also indicated in sensitivity analysis where only in very extreme cases would be project be loss making. 

References

Brealey, R. A., Myers, S. C., & Allen, F. (2014) Principles of corporate finance, 2nd ed. New York: McGraw-Hill Inc.

Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.

Northington, S. (2015) Finance, 4^th ed. New York: Ferguson

Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications

Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015). Financial Management, Principles and Applications, 6^th ed.. NSW: Pearson Education, French Forest Australia.