Concept explainers
Scenario Analysis is a technique used to identify the project’s risk and compare the bad and good circumstances with the base case scenario. It considers both the 1) sensitivity of the project’s
To carry out the scenario analysis, it is required to calculate the NPV of worst case, best case and base case, followed by the calculation of its standard deviation and co-efficient of variation. If the co-efficient of variation is higher than the average project of the company, the project should be rejected.
Expected NPV, Standard deviation of NPVs and co-efficient of variation of NPVs are calculated as below:
Here,
Probabilities of the occurrence is “
NPV for each probability is “
Standard deviation of NPVs is “
Co-efficient of Variation of NPVs is “
After conducting a scenario analysis, it is estimated, that the NPV of the project for all the three scenarios is as follows. Determine whether the project should be accepted or rejected if the maximum allowable co-efficient of variation is 0.7.
Scenario | Probability | NPV |
Best Case | 25% | $185,400 |
Base Case | 60% | $128,300 |
Worst Case | 15% | -$77,600 |
Want to see the full answer?
Check out a sample textbook solution- The CFO of Carrie Electric Auto, Mary Scofield is debating an investment. The investment is projected to earn $100,000 annually and will require the company to acquire $600,000 in assets. The following chart summarizes Mary’s decision: Before Investment After Investment Sales $ 3,500,000 $ 4,100,000 Operating Income $ 600,000 $ 700,000 Average Operating Assets 3,000,000 3,600,000 Calculate: Assume Mary is evaluated based on growth in the company’s ROI. Compute the Return on Investment including the margin and turnover components for the company before and after the investment. Would you recommend Mary make the investment? Why (refer to margin and turnover in your answer)? Assume Mary is evaluated based on growth in the company’s residual income. The company’s required rate of return is 15%. Compute the company’s residual income before and after the investment. Would you recommend Mary make the investment? Give at least one…arrow_forwardAt the last board meeting of company X, a producer of IT equipment, management raised the issue of scaling up current production to meet increased demand. The management team gave a presentation of the project, which is thought to have an internal rate of return of 9%. The yield to maturity on the company’s bonds is 5%, but the company’s implied cost of equity is 15% and the company has a debt to equity ratio equal to one. Some directors strongly argued that the company should consider borrowing to finance the expansion. Others thought that, given the company’s cost of capital, the expansion project was not worth pursuing. Who do you think is right? In no more than 200 words, give reasons for your answer starting with the case of perfect capital markets and then referencing other potentially relevant corporate finance theories and the financial frictions they rely on (e.g. taxes, bankruptcy costs, etc.).arrow_forwardYou have estimated the current-year EBITDA of Mallock Transportation for a potential buyer of the firm, and you have discovered that the CEO of Mallock, who owns 90% of the firm, is taking a salary that is at least $100,000 higher than the cost of an outsider that could be hired to run the firm. The CEO will retire upon the sale, and the firm expects no loss in revenue since clients have signed long-term contracts that will be difficult to cancel. You adjust EBITDA to account for the CEOs replacement. The adjustment is called: a. Fraud b. Business judgment c. Accounting under GAAP d. Normalizing EBITDA e. None of the abovearrow_forward
- Fountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm’s only activity and that the firm will close one year from today. The company is obligated to make a $4,100 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects: Economy Probability Low-Volatility Project Payoff High-Volatility Project Payoff Bad .50 $ 4,100 $ 3,500 Good .50 4,600 5,200 a. What is the expected value of the company if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.) b. What is the expected value of the…arrow_forwardFountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm’s only activity and that the firm will close one year from today. The company is obligated to make a $4,200 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects: Economy Probability Low-Volatility Project Payoff High-Volatility Project Payoff Bad .50 $ 4,200 $ 3,400 Good .50 4,600 4,900 a. What is the expected value of the company if the low-volatility project is undertaken? What if the high-volatility project is undertaken? (Do not round intermediate calculations.) b. What is the expected value of the company’s equity if the low-volatility…arrow_forwardYou have been asked by your employers to demonstrate your knowledge in business valuation process, by analyzing the value of Best Group Savings and Loans Company (BGSLC). The company paid a dividend of GH¢ 250,000 this year. The current return to shareholders of companies in the same industry as BGSLC is 12%, although it is expected that an additional risk premium of 2% will be applicable to BGSLC, being a smaller and unquoted company. Compute the expected valuation of BGSLC, if: The current level of dividend is expected to continue into the foreseeable future The dividend is expected to grow at a rate 4% par into foreseeable future The dividend is expected to grow at a 3% rate for three years and 2% afterwardsarrow_forward
- Sheaves Corporation economists estimate that a good business environment and a bad business environment are equally likely for the coming year. Management must choose between two mutually exclusive projects. Assume that the project chosen will be the firm’s only activity and that the firm will close one year from today. The firm is obligated to make a $4,400 payment to bondholders at the end of the year. The projects have the same systematic risk, but different volatilities. Consider the following information pertaining to the two projects: Economy Probability Low-VolatilityProject Payoff High-VolatilityProject Payoff Bad .50 $4,400 $3,800 Good .50 5,050 5,650 a. What is the expected value of the firm if the low-volatility project is undertaken? What if the high-volatility project is undertaken? (Do not round intermediate calculations and round your answers to the nearest whole dollar, e.g., 32.) b. What is the…arrow_forwardYou are valuing Estelle Company, a private firm that manufactures shop tools, and you have identified several comparable firms that are publicly owned from which to calculate an estimated price-to-earnings multiple to use in your valuation. One of the comparable firms, Comp A, has a market value per share of $53.40, earnings per share for last year of $4.20 per share, a dividend for last year that was $1.10 per share, forecast earnings per share for the next year of $7.05, and a dividend that is expected to be unchanged. The forward price-to-earnings multiple for Comp A is: a. 17.2 b. 12.7 c. 9.0 d. 7.6 e. None of the above.arrow_forwardSheaves Corporation economists estimate that a good business environment and a bad business environment are equally likely for the coming year. Management must choose between two mutually exclusive projects. Assume that the project chosen will be the firm’s only activity and that the firm will close one year from today. The firm is obligated to make a $5,400 payment to bondholders at the end of the year. The projects have the same systematic risk, but different volatilities. Consider the following information pertaining to the two projects: Economy Probability Low-VolatilityProject Payoff High-VolatilityProject Payoff Bad .50 $5,400 $4,800 Good .50 6,550 7,150 a. What is the expected value of the firm if the low-volatility project is undertaken? What if the high-volatility project is undertaken? (Do not round intermediate calculations and round your answers to the nearest whole dollar, e.g., 32.) b. What is the…arrow_forward
- Stephens Electronics is considering a change in its target capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate, rRFrRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm s tax rate is 40%. Currently, the cost of equity, rsrs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt?arrow_forwardGarret Simpson Investments is evaluating a firm (Garp, Inc.) for recommendation to its clients and trying to evaluate the firm's current stock price. The firm is about to offer its shares to the public and had earnings last year of $2.50 a share, which the analysts believe is expected to grow by 20% next year. Similar firms in the industry are currently selling for price-earnings ratios ranging from ten to fifteen times current period earnings. However, these competitor firms are already public entities and have relatively low growth expectations for their earnings. What is your estimate of an appropriate price range for the shares of Garp? Defend your answer.arrow_forwardSuppose the compensation committee for a corporation is preparing to hire a new CEO and debating which of two pay packages to offer. Package A includes an annual salary of $1 million plus 1000 shares of stock. Package B also has a salary of $1 million, but has 10,000 options to purchase the company at its current price of $50. a) Draw a graph showing the relationship between the CEO’s total compensation (vertical axis) and the stock price (horizontal axis) for the two pay schemes. Clearly label the two compensation methods in your graph. b) Discuss how a switch from the stock to stock option plan would alter CEO behavior. c) Discuss how a switch from the stock to stock option plan would affect the type of CEO that would be willing to accept the job.arrow_forward
- EBK CONTEMPORARY FINANCIAL MANAGEMENTFinanceISBN:9781337514835Author:MOYERPublisher:CENGAGE LEARNING - CONSIGNMENT