Interactive Tutorial for Topic 7

Week 9–T1 2020
Capital Budgeting II
Risk Analysis and Project Evaluation
HI5002 Interactive Tutorial for Topic 7
Group assignment:
Part 1. Research and fact finding of Australian financial market:
1.1. Comparison of four key financial institutions: commercial banks, insurance companies,
investment banks and investment funds
1.2. Analysis of three financial management questions: (i) capital budgeting, (ii) capital structure
and (ii) working capital management
Part 2. Fact Finding of Australian financial market regulation:
2.1. Fact finding of the listing on ASX
2.2. Fact Finding of requirements on Financial advisory service registration in Australia
Part 3. Risk Analysis and Project Evaluation: Questions in this Interactive Session are
designed to guide you to do Group Assignment Part 3. Sensitivity Analysis.
HI5002 Interactive Tutorial for Topic 7
Research Questions: Harvard Style Referencing

1. Barber, B. M., & Odean, T. (2001, Winter 2001). The Internet and the Investor. Journal of Economic
   Perspectives, 15(1), 41-54.
2. Barber, B., & Odean, T. (2002). Online investors: Do the slow die first? Review of Financial Studies, 15(2),
   455-488. doi: 10.1093/rfs/15.2.455.
3. Duong, P. (2016). Impacts of the 2008 global financial crisis on securities market supervision and
   implications for emerging markets: regulatory perspectives (PhD thesis). Southern Cross University,
   Lismore, NSW;
4. Duong, P., Eddie, I., & Liu, J. (2013). Development of the regulatory framework of securities market
   supervision post-GFC. Chapter 14 In H. Dincer & Ü. Hacioglu (Eds.), Globalization of Financial Institutions:
   A Competitive Approach to Finance and Banking (pp. 185-199). New York, United States: Springer
   International Publishing
   Fact Finding Questions: Harvard style Website referencing
5. IOSCO (2012). Principles for ongoing disclosure for asset-backed securities (Consultation Report of
   Technical Committee No, IOSCOPD372). Retrieved from http://
   www.iosco.org/library/pubdocs/pdf/IOSCOPD372.pdf
   HI5002 Interactive Tutorial for Topic 7
   Question 1: What is Sensitivity Analysis?
   Sensitivity analysis is conducted when a financial manager evaluates the effect of each value
   driver on the investment’s NPV. It helps identify the variable that has the most important
   impact on the NPV.
   Value drivers:

• Sales
• Unit price
• Fixed Costs
• Variable cost per unit
  HI5002 Interactive Tutorial for Topic 7
  Question 2: What are OFC and NOPAT abbreviations for? Write down formulas for OFC and
  NOPAT?
  OFC = Operating Cash Flow
  NOPAT = Net Operating Profit After Tax
  OFC= Cash Flow from Operating Activities = Net income + Noncash Expenses (depreciation)
• Changes in Working Capital. Operating CF is defined in the following equation:
  OCF t = NOPAT t + Depreciation Expense t
  NOPAT = Operating Profit – Tax = Operating Income x (1 – Tax Rate)
  Notes: Estimating CFs from operations begins with an estimate of operating profit: Subtract
  DEPRECIATION expense when calculating operating profit because it is a tax–deductible
  expense. Then calculate the firm’s tax liability based on operating profit, calculate NOPAT and
  then add back the DEPRECIATION expense.
  HI5002 Interactive Tutorial for Topic 7
  Question3: Bunnings Store is considering a potential project with a new product that is expected to sell for an
  average price of $25 per unit and the company expects it can sell 400 000 unit per year at this price for a period
  of 4 years. Launching this project will require purchase of a $2 500 000 equipment that has residual value in four
  years of $500 000 and adding $ 500 000 in working capital which is expected to be fully retrieved at the end of
  the project. Other information is available below:
  Depreciation method: straight line
  Variable cost per unit: $10
  Cash fixed costs per year: $350 000
  Discount rate: 15%
  Tax Rate: 30%
  Required: Do an analysis with cash flows of the project to determine the sensitivity of the project NPV with the
  following changes in the value drivers and provide your results in (a) relevant tables:
  Unit sales decrease by 20%
  Price per unit decreases by 20%
  Variable cost per unit increases 20%
  Cash fixed cost per year increases by 20%

Step 2: Identify the strategy to solve the problem
 The objective of this analysis is to explore the effects of the prescribed
changes in the value drivers on the project’s NPV.
 We estimate the project’s NPV for estimates of each of the value drivers that
deviate 20% from their expected or base–case value.
 We then compare the resulting NPVs to the base–case NPV (calculated
using the expected values for all the value drivers) to determine which value
driver has the greatest influence on NPV.
HI5002 Interactive Tutorial for Topic 7
Step 3: Solve the problem
 Estimating CFs from operations begins with an estimate of operating profit:
Subtract DEPRECIATION expense when calculating operating profit
because it is a tax–deductible expense. Then calculate the firm’s tax liability
based on operating profit, calculate NOPAT and then add back the
DEPRECIATION expense.
 When calculating the increase in tax, ignore interest expense to avoid
double counting the interest expense. No interest or other costs of financing
are deducted in determining the project’s free CF

Analysis: The results show that NPV is most sensitive to changes in the unit
price and unit sales. 20% decrease in unit price reduces the NPV by 43% and
20% decrease in unit sales reduce the NPV by 25.8%. Thus, management must
be doubly sure that the estimates on these value drivers are accurate and that
these two value drivers are closely monitored. However, NPV of this project
seems least sensitive to fixed cash cost, where 20% increase in fixed cost only
cause a reduction of 1.5% in NPV.