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Homework answers / question archive / Karatazi Ltd, which has a cost of capital of 12 per cent, is considering the investment of Kshs
Karatazi Ltd, which has a cost of capital of 12 per cent, is considering the investment of Kshs. 7m in an improved moulding machine project with a life span of four years.
The garden ornaments produced will retail at Kshs. 9.20 each and cost Kshs. 6 each to make. It is expected that 800,000 ornaments will be sold each year.
Required:
Using sensitivity analysis determine the key variables to this investment for the project?
| For using sensitivity analysis in a project | ||||||
| 1. We first need to calculate the NPV of the project. | ||||||
| 2. Then shock each variable in the unfavourable direction and calculate the NPVs. | ||||||
| 3. The variable, which impacts the NPV most, is the most critical factor | ||||||
| Calculation of NPV: | ||||||
| Cost of capital : 12% | ||||||
| Cost of investment: 7,000,000 | ||||||
| Life: 4 years | ||||||
| Expected production: 800,000 units | ||||||
| Selling prce: 9.20 | ||||||
| Cost: 6.00 | ||||||
| Annual cashflow = units produced * (selling price per unit - cost per unit) | ||||||
| = 800,000 * (9.2 - 6) | ||||||
| 25,60,000 | ||||||
| NPV = Annual cashflow * Present value annuity factor (Cost of capital, period) - initial investment | ||||||
| = 2,560,000 *PVAF (12%, 4) - 7,000,000 | ||||||
| = 2,560,000 * 3.0373 - 7,000,000 | ||||||
| 7,75,488 | ||||||
| Now, we will check the sensitivity of NPV by shcoking the variables towards unfavourable direction (assume 10%): | ||||||
| i) Increase in cost of investment by 10% | ||||||
| NPV = Annual cashflow * Present value annuity factor (Cost of capital, period) - initial investment | ||||||
| = 2,560,000 *PVAF (12%, 4) - 7,700,000 | ||||||
| = 2,560,000 * 3.0373 - 7,700,000 | ||||||
| 75,488 | ||||||
| Fall in NPV % = (775,488-75488)/775,488 | ||||||
| 90.27% | ||||||
| ii) Increase in cost of capital by 10% | ||||||
| NPV = Annual cashflow * Present value annuity factor (Cost of capital, period) - initial investment | ||||||
| = 2,560,000 *PVAF (13.2%, 4) - 7,000,000 | ||||||
| = 2,560,000 * 2.962 - 7,000,000 | ||||||
| 5,82,720 | ||||||
| Fall in NPV % = (775,488-582,720)/775,488 | ||||||
| 24.86% | ||||||
| iii) Decrease in annual cashflow units by 10% | ||||||
| NPV = Annual cashflow * Present value annuity factor (Cost of capital, period) - initial investment | ||||||
| = 2,304,000 *PVAF (12%, 4) - 7,000,000 | ||||||
| = 2,304,000 * 3.0373 - 7,000,000 | ||||||
| (1,75,552) | ||||||
| Fall in NPV % = (775,488-(-175,552))/775,488 | ||||||
| 122.64% | ||||||
| Hence, annual cashflow is the most critical variable |
