Project Risk Analysis -Sensitivity Analysis. HMG is considering the manufacture of a new chemical compound that is used to make high-pressure plastic containers. An investment of $4 million in plant and equipment is required. The firm estimates that the investment will have a five year life, using straight-line depreciation towaard a zero salvage value. However, the investment has an anticipated salvage equal to 10% of its original cost. The number of pounds of the chemical compound that HMG expects to sell over the five year life of the project are as follows (in millions): 1, 1.5, 3, 3.5, and 2. To operate the new plant, HMG estimates that it will incur additional fixed cash operating expenses of $1 million per year and variable operating expenses equal to 45% of revenues. Furthermore, HMG estimates that it will need to invest 10% of the anticipated increase in revenues each year in net working capital. The price per pound for the new compound is expected to be $2 in Years 1 and 2, then $2.50 per pound in Years 3 through 5. HMG’s tax rate is 38%, and it requires a 15% rate of return on its new product investments.
a. What are the key sources of risk that you see in this project?
b. Use the “goal seek” function within Excel to find the breakeven values for each of the following variables: the initial CAPEX, the working capital percentage of revenue growth, variable cost % of sales, and sale volume
c. Which of the variables analyzed in part b do you think is the greatest source of concern? What, if anything, could you do to reduce the risk of the project?
d. Should you always seek to reduce project risk?