ACC 7020 Module 3 Written Assignment: Project Cash Flows, Valuation and Risk Example

A Recyclable Fiber Line Under Uncertainty: Cash Flows, NPV and Scenario Analysis for a Packaging Project

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MBA in Accounting, Thomas Edison State University

ACC-7020: Financial Essentials for Accountants

Mentor Name

Month Day, Year

A Recyclable Fiber Line Under Uncertainty: Cash Flows, NPV and Scenario Analysis for a Packaging Project

Introduction

Capital budgeting evaluates long-term investments by comparing the present value of their incremental cash flows with their cost. Ehrhardt and Brigham (2024) count only cash flows the project changes, leaving out sunk costs, including opportunity costs and working capital and letting the discount rate carry financing costs. Because forecasts are uncertain, a single NPV is not enough; managers also need to know what happens if key assumptions are wrong.

Part A: Incremental Cash Flows

A $1.2 million market study done last year is sunk and excluded. The plant space the line will use could otherwise be leased for $0.4 million a year; that opportunity cost is already included in the fixed costs. Interest on any debt used is excluded because the discount rate reflects financing.

Two other effects were considered and excluded. The new line could take some sales from Ridgeline's existing plastic containers, but marketing expects retailers to switch to recyclable packaging from competitors regardless, so no cannibalization is charged. And because the project uses straight-line depreciation for simplicity, the analysis slightly understates its value; accelerated tax depreciation would move deductions earlier and raise NPV.

Part B: Evaluation at a Risk-Adjusted Rate

The project is riskier than Ridgeline's average because demand for recyclable containers depends on retailer commitments and regulation, so the controller adds 1.5 points to the 8.52 percent WACC and rounds to 10 percent.

All measures favor acceptance. The IRR assumes reinvestment of interim cash flows at 18 percent, which is unrealistic; the MIRR, which assumes reinvestment at the cost of capital, gives a more conservative picture. Ridgeline's mix of measures is typical; Graham and Harvey (2001) found NPV and IRR in wide use among large firms, often with payback beside them.

Part C: Sensitivity and Break-Even

Sales is the most uncertain input. The NPV reaches zero at annual sales of about $42.7 million, 18 percent below the base forecast. Each $1 million change in annual sales moves NPV by about $1.28 million, because each dollar of sales adds 45 cents of contribution, or about 34 cents after tax, for five years. Variable cost is the second most sensitive input: a rise from 55 to 60 percent of sales would cut annual cash flow by $1.95 million and NPV by about $7.4 million.

Part D: Scenario Analysis

The standard deviation of NPV is about $9.1 million, and the coefficient of variation is about 0.86, meaning the outcome is quite uncertain relative to its expected value. There is a one-in-four chance of losing value.

Scenario analysis complements sensitivity analysis. Sensitivity changes one input at a time, but in practice weak demand would likely bring lower prices and higher unit costs together. The worst case combines those effects, so its $3.51 million loss is a more realistic picture of downside risk than any single sensitivity test.

Recommendation

Ridgeline should accept the project, because its expected NPV is positive even at a risk-adjusted rate, but it should reduce the downside before committing. Signing supply agreements with two large retailers before ordering equipment would make the worst case less likely, and leasing part of the equipment would lower the initial outlay. Forecasts for new products tend to be optimistic; Kahneman and Lovallo (1993) describe how managers' bold forecasts come from focusing on the case at hand instead of the record of similar projects. The controller should compare the sales forecast with past product launches and schedule a post-audit after two years.

If the retailer agreements cannot be signed, a smaller first line with an option to expand would limit the loss in the worst case while keeping the upside.

References

Ehrhardt, M. C., & Brigham, E. F. (2024). Corporate finance: A focused approach (8th ed.). Cengage Learning.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Kahneman, D., & Lovallo, D. (1993). Timid choices and bold forecasts: A cognitive perspective on risk taking. Management Science, 39(1), 17-31. https://doi.org/10.1287/mnsc.39.1.17