Chapter_11_FA311_US2011_SS

Chapter_11_FA311_US2011_SS - Click to edit Master title...

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Unformatted text preview: Click to edit Master title style 12/29/11 1 12/29/11 Chapter 11 Project Analysis and Evaluation Click to edit Master title style 12/29/11 2 12/29/11 Key Concepts and Skills • Understand forecasting risk and sources of value • Understand and be able to conduct scenario and sensitivity analysis • Understand the various forms of break- even analysis • Understand operating leverage • Understand capital rationing and its effects Click to edit Master title style 12/29/11 3 12/29/11 Evaluating NPV Estimates • NPV estimates are just that – estimates • A positive NPV is a good start – now we need to take a closer look – Forecasting risk The possibility that errors in projected cash flows will lead to an incorrect decision how sensitive NPV is to changes in the cash flow estimates; the more sensitive, the greater the forecasting risk – Sources of value – why does this project create value? • Positive NPV investments are not all that common. Certainly limited at the firm level. Click to edit Master title style 12/29/11 4 12/29/11 Sensitivity Analysis • What happens to NPV when we change one variable at a time • This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV • The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable, and the more attention we want to pay to its estimation Click to edit Master title style 12/29/11 5 12/29/11 Sensitivity Analysis Assume you are the financial manager of Southstrom, Inc. Southstrom is considering opening a new superstore in Webberville, MI and you (and your staff) have prepared the following figures (in thousands of dollars). Assume: a. No inflation b. Investment is depreciated straight line for tax purposes c. No salvage value for land or buildings d. WACC = 8% e. Tax rate = 40% Click to edit Master title style 12/29/11 6 12/29/11 Sensitivity Analysis Year 0 Years 1-12 Investment-$5,400 1. Sales $16,000 2. Variable Costs 13,000 3. Fixed Costs 2,000 4. Depreciation 450 5. Pretax Profit (1-4) 550 6. Taxes (40%) 220 7. Profit after tax (NI) 330 8. Cash flow from operations (4+7)-$5,400 $780 Click to edit Master title style 12/29/11 7 12/29/11 Sensitivity Analysis Begin by calculating the base case NPV. The base case uses the initial projections (your “best” estimates). Financial Calculator: CF0-5,400,000 CF1 780,000 F01 12 I 8 CPT PV = $478,141 The NPV is positive but when we invest we want to “push” the numbers a little. What if one of our assumptions are incorrect? We try to find the key variables that are critical to the project’s success and see how sensitive they are to the data changes....
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This note was uploaded on 12/28/2011 for the course FI 311 taught by Professor Booth during the Fall '06 term at Michigan State University.

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Chapter_11_FA311_US2011_SS - Click to edit Master title...

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