Sensitivity analysis

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Do number 9 which is perform appropriate sensitivity analysis

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Key West Electronics
Key West Electronics was just ten years old in early 2018, with sales expected to pass the $500
million and net income just beginning to turn positive after years of losses or near break-even.
After nine years of operations, the combined losses totaled close to $20 million, and only a
fresh infusion of capital and a new CEO kept the company in business.
The industry was changing so rapidly that the initial product line lost its market eighteen
months after its introduction and start of production. Key West had planned for new products
to come on line, but the philosophy of making products compatible with all systems held back
introduction. Although the company had begun to recover from some of its early difficulties, a
new strategy had to be developed if the growth in sales that brought the company to a half
billion-dollar level was going to become profitable.
The new CEO of the company, George Ramos, came from outside the computer manufacturing
area. Ramos was hired at the insistence of the venture-capital company that controlled Key
West Electronics. Ramos realized that characterizing market uncertainty was a key factor in
helping shape a long-term plan of action.
Key West, because of its technical expertise, had been considered to be a leader in the market,
but a new company, Allied Enterprises, had recently been started. Ramos was uncertain as to
exactly what markets Allied would enter, but the consequences for Key West Electronics would
be significant if Allied were to enter into similar markets. If their products were to compete,
profit margins for both companies would be reduced, and neither would make a reasonable
rate of return.
A final concern for Ramos was in the area of production. Cost estimates were notoriously
unreliable for new products.
Ramos and Key West Electronics need to decide on production of a new memory expansion
system (MES). This system, as proposed, would expand the memory and capability of a wide
range of computer platforms. Based on an initial evaluation, it appeared the product would
offer significant profits over its expected six-year life. It was known that none of the major
manufacturers had plans for development of similar products and only Allied had the potential
for development and marketing of a competing product. If successful, the new line, would lead
Key West into a period of sustained profitability. Data on the proposed system is shown in the
following table:
•
•
•
•
Plant Cost $60 million
Life 6 years
Tax Rate 40%
Salvage $0/Depreciated on straight-line basis over life of 6 years
The uncertainty in the project revolved around three areas: market size, market share, and cost
of production. Excerpts from the project proposal concerning risk were as follows.
•
The market size is expected to be either $300 million or $200 million each year for the
next six years.
•
The major threat is whether or not Allied will bring out a competing product at the same
time as the introduction of the Key West Electronics MES line. Based on the current
competition, it would appear that in the absence of Allied coming into the game, Key West
market share would be 30 per cent for each of the next six years. In the event that Allied does
introduce a product, that product would take 10 points from our share and leave us with 20 per
cent of the market for the next six years. Our estimate is that the probability of this occurring is
50 per cent.
•
The production of the MES will require a costly manual assembly process. There is an
automated system that can be licensed but may not work for the quantities that are needed. In
the absence of that system the estimate is that costs, exclusive of depreciation, will be 70 per
cent of sales. If the new production system can be used the will be reduced to 60 per cent of
sales. Our estimate is that the probability of the system being applicable is 50 per cent. There
are no savings in the initial outlay, because our cost of the new system is based solely on our
use of it.
Ramos wanted risk taken into account in all capital projects and had developed the following
criteria for any project to be acceptable.
•
•
The NPV of the expected value of the after-tax cash flows had to be positive at the 16
per cent discount rate.
The NPV of the cash flows, using the worst case, had to be no less a loss than 20 per
cent of the project outlay.
Stefanie Murphy, the president of Key West Electronics, evaluated the MES following the
recommendations of Ramos.
•
The venture showed a positive net present value on its expected cash flows. This meets
the first of the Ramos decision criteria.
•
The second criterion was a risk under a worst-case scenario. The project’s NPV under
this situation could not be less than a loss of 20 per cent of the project cost. After
conducting this test, it seemed that the MES was a ‘No Go’ because it failed the worstcase scenario standard.
However, Murphy ultimately decided that the worst-case scenario should not be used alone in
evaluation of any project. As an alternative, Murphy proposed that all possible outcomes be
computed for the project. From this set of outcomes, a mean and standard deviation could be
calculated. Using these statistics an estimate could be made regarding the probability that the
project would have a positive NPV.
Ramos agreed that the project should be reevaluated using the following revised criteria
proposed by Murphy:
•
•
•
The expected value of the NPV must be positive.
The probability that the NPV was zero or greater must be at least 60%.
The probability that the loss would be no more than 20% of the project cost would be
no more than 10%.
Go or No-Go for MES??
Case Objectives and Questions:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Compute the net cash flows for year’s 1-6.
Compute the NPV on the expected value of the net cash flows.
Compute the net cash flows for the worst-case scenario.
Compute the NPV on the cash flows for the worst-case scenario.
Evaluate the risk criteria that Ramos uses.
Compute the NPV for each of the eight possible sets of conditions from the data.
Compute the mean and standard deviation of the project NPV’s using the eight values.
Evaluate the risk criteria that Murphy uses.
a.
Is the expected value of the NPV’s greater than zero?
b.
Is the probability that the NPV is equal to or greater than zero 60 per cent or
more?
c.
Is the probability that the loss would be no more than 20% of the project
investment less-than-or-equal-to10%?
d.
If the answer to part c is no then what is the potential loss associated with a
probability of 10% or less?
Perform appropriate sensitivity analysis.
What is a revised approach to making this decision that you think Ramos and Murphy
would accept but would also lead to ‘Go’ decision for the MES?
Investment
60
Before Tax Profit
Depreciation
Taxable Cash
Tax (40%)
After Tax
PV Cash Flows
NPV
1
36
10
26
10.4
25.6
22.07
34.33
2
36
10
26
10.4
25.6
19.02
3
36
10
26
10.4
25.6
16.40
4
36
10
26
10.4
25.6
14.14
Key West best case scenario NPV for the memory expansion system (MES)
300 Market cap (mil)
30% Large share
90 Sales (mil)
54 Low Cost (mil)
36 Cash flow
Discount Rate
16%
5
36
10
26
10.4
25.6
12.19
6
36
10
26
10.4
25.6
10.51
2X2X2
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