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Investment Decisions Based on Sensitivity Analysis

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Remember to show any assumptions that you used. All payments occur at the end of the period unless stated otherwise. Interest is compounded annually unless stated otherwise. Face value of all bonds is $1000. Use a Word document and an Excel spreadsheet. (see attached for better formatting)

1. Cupcake Corp. is considering an investment of $40 million in plant and machinery. This is expected to produce sales of $23 million in year 1, $26 million in year 2, and $30 million in year 3. Subsequent sales are expected to increase by 10% each year for the remaining 2 years. The plant and machinery will be scrapped after 5 years with a salvage value of $10 million. The property and machinery belong to the 3 year recovery period class for depreciation purposes (MACRS). Cost of goods sold (COGS) is expected to be $8 million in year 1, $14 million in year 2, and to increase at 9% each year for the remaining 3 years. Fixed operating expenses are $1,000,000 per year. Year-end net working capital (NWC) is given below. The corporate tax rate is 40%.
k = 000s | 0 | 1 | 2 | 3 | 4 | 5
NWC | 500k | 700k | 800k | 800k | 500k | 0

a) Calculate the free cash flows for time 0 through time 5.
b) Calculate the net present value (NPV) for a 12% cost of capital.
c) Find the internal rate of return (IRR).
d) Calculate the sensitivity of the investment to a change in the cost of capital (it could be as low as 8% or as high as 16%).
e) Should Cupcake make the investment? Why or why not?

Comments:

- You need to consider the added investment in net working capital (NWC) for each period. The problem gives the total amount of NWC for that period. Cupcake initially invests $500,000 in NWC. At the end of the first year, NWC increases to 600,000 so the firm has increased its investment in NWC by $100,000. This process continues over the project's life until all of the NWC is returned in last year.

- Taxes: The project is part of a larger firm, so any operating losses can be used to offset gains in other areas. This would produce a tax savings for that year

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Solution Preview

Dear Student:

Cupcake Corporation: all calculations are made in the attached Excel worksheet, where you can check the cell references.

a) Calculate the free cash flows for time 0 through time 5.

The formula for annual incremental cash flows
For year 0 = initial investment + investment in net working capital (negative)
for years 1 to 4 = (Sales - Costs)*(1-T) + Depreciation*T + change in Net Working Capital
for year 5 = (Sales - Costs)*(1-T) ...

Solution Summary

This solution shows in detail how Cupcake Corporation analyzes the profitability of a 5-year project using free cash flows and annual changes in net working capital. The initial investment is $40 million, the annual sales and cost of goods sold vary, and a salvage value is accounted for after 5 years. The results calculate the net present value (NPV), the internal rate of return (IRR), and the sensitivity of the investment to changes in the cost of capital.

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See Also This Related BrainMass Solution

Capital Budgeting and Sensitivity Analysis Paper

Details:
In this assignment, Bigtime Conglomerate is making a decision to acquire BG Enterprises. The learner will review and modify, as necessary, the model for the Capital Budget and perform two sensitivity analyses of the data. The learner will write a paper that summarizes the changes in the model based on changes made, contrast the two analyses, correlate the purchase to internal competencies, and detail how the analyses affect the decision to acquire BG Enterprises.

General Requirements:
Use the following information to ensure successful completion of the assignment:

Refer to "Example of Capital Budgeting Model."
Refer to "Capital Budgeting Model."

This assignment requires that at least two additional scholarly research sources related to this topic, and at least one in-text citation from each source be included.

Directions:
Use the "Capital Budgeting Model" file and the instructions noted within the file to do the following:

1) Complete the capital budgeting model using "Capital Budgeting Model."
2) Perform two types of sensitivity analysis.

Write a paper (1,250-1,500 words) contrasting the sensitivity analysis types used, summarizing how results adjust, and detailing how your analyses affect decision making. Include the following in your paper:

1. Offer a research-based contrast of and rationale for the sensitivity analysis types used and the results achieved by each.
2. Summarize how the model results adjust to changes in key input variables.
3. Summarize market conditions that support or oppose the acquisition.
4. In your conclusion, detail how the data gathered affect the decision to acquire BG Enterprises.

I have finished this assignment on my own but I felt lost the entire time. My instructor is not readily available for help and I couldn't schedule a tutor before the paper is due. I just want something to compare my assignment to from someone that understands the instructions.

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