Business Value Model
The company's objective is to maximize the Net Present Values (NPVs)
of all the projects it undertakes. In order to evaluate each alternative
we have to build a financial model that would calculate the cash flows
and NPVs of all possible outcomes.
Financial Data
The money for construction, equipment and other expenses will have to be
allocated before the project starts. Each plant will be available for operation
a year after the construction begins. Each of the plants will be in operation
for ten years.
VOSI expects to be able to achieve the economies of scale, meaning that
the per unit cost of production on the larger plant will be less than that
for the smaller plant. The per unit cost of production for the first year
can be estimated very accurately based on the current costs. The estimation
of the average revenue per unit for the first year of production is based
on its current wholesale price.
|
Total construction costs
|
Additional capacity (units/year)
|
Estimated cost of production (per unit)
|
Estimated average revenue (per unit)
|
Plan Alpha
|
$1 million
|
90,000
|
$220
|
$500
|
Plan Beta
|
$30 million
|
300,000
|
$210
|
$500
|
Plan Gamma
|
$75 million
|
800,000
|
$200
|
$500
|
Uncertainties
The annual cost of production and revenue per unit are unknown and are
impossible to predict. However, the experts in purchasing and sales departments
may have a good idea of the range in which these numbers may fall - the
distribution of the variable.
One of the convenient ways to represent this distribution is by assessing
10-50-90 (or Low, Base, and High) points. This means that there is only
10% chance that the actual value will be less than the "Low" value, and
there is only 10% chance that it will be above the "High" value. The variable
has a 50-50 chance of being below or above the "Base" value.
Market success can be either "High" or "Low". We will use High market
success as a base case.
|
Low
|
Base
|
High
|
Market Success
|
Low
|
High
|
|
Change in Price
|
8%
|
10%
|
14%
|
Change in Cost
|
0%
|
2%
|
4%
|
Dependency
The change in price and the market success both define the average demand
(in units) over the next ten years.
|
Market Success
|
Change in Price
|
Low
|
High
|
8%
|
20,000
|
300,000
|
10%
|
40,000
|
400,000
|
14%
|
60,000
|
500,000
|
Financial Model
In order to evaluate the NPV of each alternative the following simple cash
flow statement is constructed for eleven years starting with year 0 when
the money is allocated for the construction. Note, that for simplicity
the NPV is calculated without taking taxes into the consideration. The
cash flow model contains the following data:
Revenue -
price per unit multiplied by the number of units sold, which is the smallest
of the number demanded and the number produced. Price per unit is adjusted
for every year, starting with the second, by the average change in price.
Production
cost - number of units sold (same as above) multiplied by the per unit
production cost for corresponding alternative. Cost per unit is adjusted
for every year, starting with the second, by the average change in cost.
Construction
cost - the negative cash flow in year zero.
Profit - for
each year, the difference between the revenue and the production cost plus
the construction cost.
NPV - net
present value of the profits for the eleven years.
