INTRODUCTION
Sidney Johnson is conducting a budget analysis for Shrieves Casting Company. The company intends to add a new product line and will install the equipment in an unused space in the main plant. Though the machinery will cost the company in $240,000, including shipping and installation, it will produce an expected 1,250 units of product per year for four years that can be sold at $200 in the first year. Johnson is tasked with deciphering if this purchase is wise for the company.
PROBLEM STATEMENT
Johnson’s management expects the following items to justify findings:
A. Initial Indicators - Do the indicators of NPV, IRR, MIRR, PI, payback, and discounted payback suggest that the project should be undertaken?
B. Sensitivity analysis -Measure risk on potential changes to inputs.
C. Scenario analysis – Analyze the best case and worst case scenario
D. Evaluate Risk
ANALYSIS
Initial Indicators. The firm’s net present value is $87,806. The internal rate of return was found to be 24 percent. Additionally, the marginal internal rate of return was 18 percent. The payback period was calculated as 2 and a half years. While these indicators show that the project will be profitable, one must conduct further analysis to ensure the accuracy of these results.
Sensitivity Analysis. Sensitivity analysis is the measured changes of a particular variable on a project 's net present value. Also, known as a what-if analysis, this report helps identify potential financial pitfalls for the company. For this particular project, Johnson must measure the weighted cost of capital, units sold, and salvage value as the input variables. This particular type of sensitivity is considered to be a multivariate analysis, due to the number of inputs compared...
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.... The project is classified as high risk due to coefficient of variation of .69. However, this is simply the stand-alone risk of expected return. The company generally add or subtracts 3 percentage points to the overall cost of capital to adjust for risk. This brings weighted average cost of capital for a high risk project such as this to 13 percent. This gives the project an NPV of 65168 which is a valid amount to accept the project.
RECCOMENDATION:
After careful analysis of Johnson’s finding, it is with great recommendation that Shrieves accept the project. Utilizing various analysis techniques, it has been determined that this project has a great likelihood of profitability. Though there are risk associated, it is with a small deviation away from the standard project that the company normally undertakes. The new product line will be a great addition to the firm.
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