Karatazi Ltd, which has a cost of capital of 12 per cent, is considering the investment of Kshs. 7m in an improved

Question

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?

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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 =

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Karatazi Ltd, which has a cost of capital of 12 per cent, is considering the investment of Kshs

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Archived Solution

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