Corporate Finance

Risk Analysis in Capital Investments 
 237

How would you draw the decision tree for the problem?

2. In trying to decide whether to approve a development budget for an improved product, you are urged to do so on the
   grounds that the development, if successful, will give you a competitive edge. But if you do not develop the product, your
   competitor may—and may seriously—damage your market share. Draw a decision tree.


3. (a) In the BHEL case, if the project cash flows falls by 5 percent what would be the NPV and IRR? What would be the
   percentage change in NPV?
   (b) If the initial investment is equally spread over 2 years, what would be the new NPV?
   (c) If the discount rate remains constant for the first 5 years and then rises by 2 percentage points, calculate the new NPV
   and IRR.


4. The following data is available for a project:

Initial investment = Rs 10 crore (incl. working capital of Rs 2.5 crore)

Expected life = 8 years

Salvage value = 50 percent of initial investment

First year sales = Rs 6 crore

Growth rate in sales = 7.5 percent

Operating profit margin = 10 percent

Tax rate = 35 percent

Cost of capital = 17 percent

Increase in W.C. = 5 percent

Depreciation is provided on a straight-line basis. Estimate cash flows and NPV. Conduct a sensitivity analysis by changing

key assumptions.

5. Find the financial break-even point for the example given above.


6. Find the accounting break-even point for a project that has the following characteristics:

Fixed cost = Rs 50 crore

Sales revenue/unit = Rs 1,000

Variable cost/unit = Rs 800

7. For two mutually exclusive investments, the management of the company has developed cash flow estimates as pessimistic,
   most likely, and optimistic.

AB

Investment 5,500 5,500

Pessimistic 200 700

Most likely 800 800

Optimistic 1,400 900

Both projects have a life of 15 years. Cost of capital = 14 percent. Which project is more risky? Recalculate NPV if the

probabilities of the three situations are 30 percent, 50 percent and 20 percent respectively.

A MINI CASE: VALUATION OF FOREIGN DIVISIONS

In 1997, a US multinational requested a ‘bulge bracket’ investment bank to value two of its divisions in Argentina and

Brazil. Will Smith, an analyst with the bank, was asked to forecast free cash flow and estimate suitable discount rates for

each of these divisions. Exhibit 1 presents the forecast of free cash flow for the two divisions: