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The document discusses capital investment decisions in energy project evaluation, focusing on relevant incremental cash flows, the stand-alone principle, sunk costs, opportunity costs, and erosion. It includes a detailed example of a new stereo amplifier project, outlining the pro forma income statements, operating cash flows, and NPV calculations to determine project feasibility. Additionally, it addresses forecasting risk and various analyses (scenario, sensitivity, and simulation) that financial managers should consider when evaluating projects.

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Asith Savinda
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5 views

Assignment 2 Answers

The document discusses capital investment decisions in energy project evaluation, focusing on relevant incremental cash flows, the stand-alone principle, sunk costs, opportunity costs, and erosion. It includes a detailed example of a new stereo amplifier project, outlining the pro forma income statements, operating cash flows, and NPV calculations to determine project feasibility. Additionally, it addresses forecasting risk and various analyses (scenario, sensitivity, and simulation) that financial managers should consider when evaluating projects.

Uploaded by

Asith Savinda
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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MASTER OF ENERGY MANGEMENT_2021 • DMM9210

Planning and Implementation of Energy Projects

ASSIGNMENT 2 ANSWERS
Part 1 – Making Capital Investment Decisions
1. What are the relevant incremental cash flows for project evaluation?

The incremental cash flows for project evaluation consist of any and all
changes in the firm’s future cash flows that are a direct consequence of taking
the project.

2. What is the stand alone principle?

Evaluation of a project based on project’s incremental cash flows.

3. What is sunk cost?

A sunk cost is a cost that has already been incurred and cannot be removed
and therefore should not be considered in an investment decision.

4. What is an opportunity cost?

An opportunity cost is the most valuable alternative that is given up if a


particular investment is undertaken.

5. Explain what erosion is and why it is relevant.

The cash flows of a new project that comes at the expense of a firm’s existing
business.

It will account for any side effects which could occur for any multiline
consumer producer or seller.

6. Explain why interest paid is not a relevant cash flow for project
evaluation.

In analyzing a proposed investment, we will not include interest paid. We are


interested in the cash flow generated by assets of the project. Interest paid is
a component of cash flow to creditors, not cash flow from assets. Our goal in
project evaluation is to compare the cash flow from a project to the cost of
acquiring that project in order to estimate NPV.

7. What is the definition of project operating cash flow? How does this
differ from net income?

Operating cash flow =


Earnings before interest & taxes (EBIT) + Depreciation - Taxes

Net income contains depreciation a non-cash item. Operating cash flow is


equal to net income plus depreciation.

8. Our firm plans to introduce a new type of Stereo amplifier. We think we


can sell 500 units per year at a price of $10,000 each. Variable cost per
amplifier will be about $5,000 per unit, and the product will have a 4
year life.
Fixed cost will be $610,000 per year. The total investment in the
manufacturing equipment is $1,050,000. This equipment is depreciated
over a 7 year period on straight line basis. In four years, the equipment
will be worth about half of what we paid for it. We will have to invest
$900,000 in net working capital at the start. After that net working
capital requirements will be 30% of sales.
Should we undertake this venture?

(To answer, first prepare a pro forma income statement for each year.
Next, calculate operating cash flow. Finish the problem by determining
total cash flow and then calculating NPV assuming a 20% required
return. Use 34% tax rate throughout.

To develop the pro forma income statements, we need to calculate the


depreciation for each of the 4 years.

Year Depreciation Ending book value


1 150,000 900,000
2 150,000 750,000
3 150,000 600,000
4 150,000 450,000
The projected income statements are as follows:
Year
1 2 3 4
Sales 5,000,000 5,000,000 5,000,000 5,000,000
Variable costs 2,500,000 2,500,000 2,500,000 2,500,000
Fixed Costs 610,000 610,000 610,000 610,000
Depreciation 150,000 150,000 150,000 150,000
EBIT 1,740,000 1,740,000 1,740,000 1,740,000
Taxes (34%) 591,600 591,600 591,600 591,600
Net income 1,148,400 1,148,400 1,148,400 1,148,400

Based on the information, the operating cash flows are:


Year
1 2 3 4
EBIT 1,740,000 1,740,000 1,740,000 1,740,000
Depreciation 150,000 150,000 150,000 150,000
Taxes 591,600 591,600 591,600 591,600
Operating cash flow 1,298,400 1,298,400 1,298,400 1,298,400

We now have to find out the non-operating cash flows.

Net working capital starts at $900,000 and then increase to 30% of sales or
$1,500,000. This is a $600,000 addition to net working capital.

We have to invest $1,050,000 to get started. In 4 years, the book value of this
investment will be $450,000 compared to an estimated market value of
$525,000 (half the cost).

After tax salvage value = 525,000 – 0.34 X (525,000 – 450,000) = $499,500

The Projected cash flows are:

Year
0 1 2 3 4
Operating cash flow 1,298,400 1,298,400 1,298,400 1,298,400
Additions to NWC - 900,000 - 600,000 1,500,000
Capital Spending - 1,050,000 499,500
Total cash flow - 1,950,000 698,400 1,298,400 1,298,400 3,297,900
With these cash flows, the NPV at 20% is:

NPV = -1,950,000 + 698,000 /1.2 + 1,298,400/1.22 +


1,298,400/1.23 + 3,297,900/1.24
= $1,875,478
Required return 20% 1.20
Discount factor 1.00 0.83 0.69 0.58 0.48
PV - 1,950,000 582,000 901,667 751,389 1,590,422
NPV 1,875,478

So this project appears quite feasible.

Part 2 – Project Analysis and Evaluation

1. What is forecasting risk? Why is it concern for the financial manager?

The possibility that we make a bad decision because of errors in the projected
cash flow is called forecasting risk (or estimation risk).

Because of forecasting risk, there is the danger that we think a project has
positive NPV, when it really does not. Then the financial manager may decide
to invest in that project. Due to forecasting risk we think project has a
negative NPV, when it really has positive. Then we will lose a valuable
opportunity.

2. What are some potential sources of value in a project?

Our new product is significantly better than that of the competition.

We can truly manufacture at a lower cost.

We can distribute more effectively.

We can identify undeveloped market niches.

We can gain control of market?


3. What are scenario, sensitivity and simulation analyses?

Scenario analysis

The determination of what happens to NPV estimates when we ask what-if


questions.

Sensitivity analysis

Investigation of what happens to NPV when only one variable is changed.

Simulation analysis

A combination of scenario and sensitivity analyses.

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