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Break-even and Sensitivity Analysis

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The Clayton Manufacturing Company is considering an investment in a new automated inventory system for its warehouse that will provide cash savings to the firm over the next five years. The firm's CFO anticipates additional earnings before interest, taxes, depreciation, and amortization (EBITDA) from cost savings equal to $200,000 for the first year of operation of the center, and over the next year the firm estimates this amount will grow at a rate of 5% per year. The system will require an initial investment of $800,000 that will be depreciated over a five year period using straight-line depreciation of $160,000 per year and a zero estimated salvage value.

a. Calculate the project's annual project free cash flow (PFCF)for each of the next five years where the firm's tax rate is 35%.

b. If the cost of capital for the project is 12%, what is the projected NPV for the investment?

c. What is the minimum Year 1 dollar saving (i.e. EBITDA) required to produce a breakeven NPV=0

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Solution Summary

This solution illustrates how to perform a break-even analysis and a sensitivity analysis.

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Breakeven Sensitivity Analysis

The expected annual free cash flow for the GPS tracker investment from problem 3-1 is computed as follows:

Revenues 1,250,000
Variable cost 750,000
Fixed expenses 250,000
Gross profit 250,000
Depreciation 100,000
Net operating income 150,000
Income tax expense 51,000
NOPAT 99,000
Plus: depreciation 100,000
Less: CAPEX
Less: working capital investment
Free cash flow 199,000

a. Construct a spreadsheet model to compute free cash flow that relies on the following assumptions or estimates:

Base Case Estimates Values
Initial cost of equipment 1, 000,000
Project and equipment life 10 years
Salvage value of equipment 0
Working capital requirement 0
Depreciation method Straight-line
Depreciation expense 100,000
Discount rate 10.00%
Tax rate 34.00%
Unit sales 10,000
Price per unit 125.00
Variable cost per unit 75.00
Fixed costs 250,000

b. What level of annual unit sales does it take for the investment to achieve a zero NPV? Use your spreadsheet model to answer this question. (Hint: Use the Goal Seek function in Excel.)
c. If unit sales were 15% higher than the base case, what unit price would it take for the investment to achieve a zero NPV?

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