Chapter011 - Chapter 11 Chapter Project Analysis and...

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Unformatted text preview: Chapter 11 Chapter Project Analysis and Evaluation Chapter Outline Chapter Evaluating NPV Estimates Scenario and Other What-If Analyses Break-Even Analysis Operating Cash Flow, Sales Volume, and Operating Break-Even Break-Even Operating Leverage Capital Rationing Evaluating NPV Estimates Evaluating NPV estimates are just that – estimates A positive NPV is a good start – now we need to positive take a closer look take Forecasting risk – how sensitive is our NPV to Forecasting changes in the cash flow estimates; the more sensitive, the greater the forecasting risk sensitive, Sources of value – why does this project create Sources value? value? Scenario Analysis Scenario What happens to the NPV under different cash What flow scenarios? flow At the very least look at: Best case – high revenues, low costs Worst case – low revenues, high costs Measure of the range of possible outcomes Best case and worst case are not necessarily Best probable, but they can still be possible probable, New Project Example New Consider the project discussed in the text The initial cost is $200,000 and the project has a The 5-year life. There is no salvage. Depreciation is straight-line, the required return is 12%, and the tax rate is 34% tax The base case NPV is 15,567 Summary of Scenario Analysis Summary Scenario Net Income Cash Flow NPV IRR Base case 19,800 59,800 15,567 15.1% Worst Case -15,510 24,490 -111,719 -14.4% Best Case 59,730 99,730 159,504 40.9% Sensitivity Analysis Sensitivity What happens to NPV when we vary one What variable at a time variable This is a subset of scenario analysis where we This are looking at the effect of specific variables on NPV NPV The greater the volatility in NPV in relation to a The specific variable, the larger the forecasting risk associated with that variable, and the more attention we want to pay to its estimation attention Summary of Sensitivity Analysis for New Project New Scenario Unit Sales Cash Flow NPV IRR Base case 6000 59,800 15,567 15.1% Worst case 5500 53,200 -8,226 10.3% Best case 6500 66,400 39,357 19.7% Simulation Analysis Simulation Simulation is really just an expanded sensitivity and Simulation scenario analysis scenario Monte Carlo simulation can estimate thousands of Monte possible outcomes based on conditional probability distributions and constraints for each of the variables distributions The output is a probability distribution for NPV with an The estimate of the probability of obtaining a positive net present value present Making A Decision Making Beware “Paralysis of Analysis” At some point you have to make a decision If the majority of your scenarios have positive If NPVs, then you can feel reasonably comfortable about accepting the project comfortable If you have a crucial variable that leads to a If negative NPV with a small change in the estimates, then you may want to forego the project project Break-Even Analysis Break-Even Common tool for analyzing the relationship between Common sales volume and profitability sales There are three common break-even measures Accounting break-even – sales volume at which net income = Accounting 0 Cash break-even – sales volume at which operating cash flow Cash =0 Financial break-even – sales volume at which net present Financial value = 0 value Example: Costs Example: There are two types of costs that are important in There breakeven analysis: variable and fixed breakeven Total variable costs = quantity * cost per unit Fixed costs are constant, regardless of output, over some time Fixed period period Total costs = fixed + variable = FC + vQ Your firm pays $3000 per month in fixed costs. You also pay Your $15 per unit to produce your product. $15 • What is your total cost if you produce 1000 units? • What if you produce 5000 units? Example: Average vs. Marginal Cost Average Average Cost TC / # of units Will decrease as # of units increases The cost to produce one more unit Same as variable cost per unit Marginal Cost Accounting Break-Even Accounting The quantity that leads to a zero net The income income NI = (Sales – VC – FC – D)(1 – T) = 0 QP – vQ – FC – D = 0 Q(P – v) = FC + D Q = (FC + D) / (P – v) Using Accounting Break-Even Using Accounting break-even is often used as Accounting an early stage screening number an If a project cannot break even on an If accounting basis, then it is not going to be a worthwhile project worthwhile Accounting break-even gives managers Accounting an indication of how a project will impact accounting profit accounting Accounting Break-Even and Cash Flow Cash We are more interested in cash flow than we are in We accounting numbers accounting If a firm just breaks even on an accounting basis, cash If flow = depreciation flow If a firm just breaks even on an accounting basis, NPV If <0 Example Example Consider the following project A new product requires an initial investment of $5 million and will new be depreciated to an expected salvage of zero over 5 years be The price of the new product is expected to be $25,000 and the The variable cost per unit is $15,000 variable The fixed cost is $1 million What is the accounting break-even point each year? • Depreciation = 5,000,000 / 5 = 1,000,000 • Q = (1,000,000 + 1,000,000)/(25,000 – 15,000) = 200 units Sales Volume and Operating Cash Flow Cash What is the operating cash flow at the accounting What break-even point (ignoring taxes)? break-even OCF = (S – VC – FC - D) + D OCF = (200*25,000 – 200*15,000 – 1,000,000 -1,000,000) + OCF 1,000,000 = 1,000,000 1,000,000 OCF = [(P-v)Q – FC – D] + D = (P-v)Q – FC Q = (OCF + FC) / (P – v) Q = (0 + 1,000,000) / (25,000 – 15,000) = 100 units What is the cash break-even quantity? Three Types of Break-Even Analysis Analysis Accounting Break-even Where NI = 0 Q = (FC + D)/(P – v) Where OCF = 0 Q = (FC + OCF)/(P – v) (ignoring taxes) Where NPV = 0 Cash Break-even Financial Break-even Cash BE < Accounting BE < Financial BE Example: Break-Even Analysis Example: Consider the previous example Assume a required return of 18% Accounting break-even = 200 Cash break-even = 100 What is the financial break-even point? • Similar process to that of finding the bid price • What OCF (or payment) makes NPV = 0? t = 5; Initial investment = 5,000,000; r = 18%; C = 1,598,889 = 5; OCF OCF • Q = (1,000,000 + 1,598,889) / (25,000 – 15,000) = 260 units The question now becomes: Can we sell at least 260 The units per year? units Operating Leverage Operating Operating leverage is the relationship between sales Operating and operating cash flow and Operating leverage is the degree to which a project or Operating firm is committed to fixed production costs firm Fixed costs act like a lever in the sense that a small % Fixed change in operating revenue can be magnified into a large % change in OCF and NPV large The higher the DOL, the greater the variability in operating The cash flow cash The higher the DOL, the greater is the potential danger from The forecasting risk forecasting The higher the fixed costs, the higher the DOL DOL depends on the sales level you are starting from DOL = 1 + (FC / OCF) Example: DOL Example: Consider the previous example Suppose sales are 300 units This meets all three break-even measures What is the DOL at this sales level? OCF = (25,000 – 15,000)*300 – 1,000,000 = 2,000,000 DOL = 1 + 1,000,000 / 2,000,000 = 1.5 What will happen to OCF if unit sales increases by What 20%? 20%? Percentage change in OCF = DOL*Percentage change in Q Percentage change in OCF = 1.5(.2) = .3 or 30% OCF would increase to 2,000,000(1.3) = 2,600,000 Capital Rationing Capital Capital rationing occurs when a firm or Capital division has limited resources division Soft rationing – the limited resources are Soft temporary, often self-imposed temporary, Hard rationing – capital will never be Hard available for this project available The profitability index is a useful tool The when a manager is faced with soft rationing rationing ...
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This note was uploaded on 04/13/2010 for the course BUSINESS engl 102 taught by Professor Seyhanözmenek during the Spring '10 term at Middle East Technical University.

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