ch12 - Chapter 12 Evaluating Project Economics and Capital...

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Chapter 12 Evaluating Project Economics and Capital Rationing Learning Objectives 1. Explain and demonstrate how variable costs and fixed costs affect the volatility of pretax operating cash flows and accounting operating profits. 2. Calculate and distinguish between the degree of pretax cash flow operating leverage and the degree of accounting operating leverage. 3. Define and calculate the pretax operating cash flow and accounting operating profit break-even points and the crossover levels of unit sales for a project. 4. Define sensitivity analysis, scenario analysis, and simulation analysis and describe how they are used to evaluate the risks associated with a project. 5. Explain how the profitability index can be used to rank projects when a firm faces capital rationing, and describe limitations that apply to the profitability index. I. Chapter Outline 12.1 Variable Costs, Fixed Costs, and Project Risk Variable costs (VC) are costs that vary directly with the number of units sold.
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Fixed costs (FC), in contrast, do not vary with unit sales in the short run. The cash flows and accounting profits for a project are sensitive to the proportion of its costs that are variable and the proportion that are fixed. A project with a higher proportion of fixed costs will have cash flows and accounting profits that are more sensitive to changes in revenues than an otherwise identical project with a lower proportion of fixed costs. EBITDA is often called pretax operating cash flow because it equals the incremental pretax cash operating profits from a project. EBITDA = Revenue – VC – FC Op Ex = VC + FC A. Cost Structure and Sensitivity of EBITDA and EBIT to Revenue Changes By comparing the sensitivity of EBITDA to changes in revenue between two project alternatives, it may help to better understand the risks and returns for each of the alternatives. Distinguishing between fixed and variable costs will then enable us to calculate the sensitivity of EBITDA to changes in revenue. The greater the proportion that total costs are fixed will make it more difficult to adjust costs when revenue changes. EBIT is more sensitive to changes in revenue than EBITDA because the EBITDA does not include depreciation and amortization. Depreciation and amortization acts just like a fixed cost because it is based on the amount that was invested in the project.
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12.2 Calculating Operating Leverage Operating leverage is a measure of the sensitivity of EBITDA or EBIT to changes in revenue. Two measures of operating leverage are often used by analysts: the degree of pretax cash flow operating leverage and the degree of accounting operating leverage. A.
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ch12 - Chapter 12 Evaluating Project Economics and Capital...

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