Semih Yildirim ADMS 3530 9-1 Chapter 9 Project Analysis Chapter Outline How Firms Organize the Investment Process Some “What If” Questions Break-Even

Semih Yildirim ADMS 3530

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Chapter 9Project Analysis

Chapter Outline How Firms Organize the Investment

Process Some “What If” Questions Break-Even Analysis Real Options and the Value of Flexibility Capital Budgeting Practices in Canadian

Firms


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The Investment Decision• How Firms Organize the Investment Process

Once a year, a firm’s head office will generally ask each of its divisions to provide a list of the investments they would like to make.

A list of planned investments is called the capital budget. This “wish list” must then be examined to determine which projects

should go forward. Capital budgeting is a cooperative effort with some challenges:

Forecasts from divisions must be consistent Conflicts of interests must be eliminated Forecast bias must be reduced

Senior management must look behind NPVs and understand why they are positive or negative.


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Some “What If” Questions• Managers want to understand more than the NPV of a

project. If NPV is positive, they must seek to understand why such an

attractive project did not come from a competitor. And if the firm goes ahead with the project, and other copy a

such a profitable idea, will the firm still have some competitive advantage?

• They also want to predict what events could happen in an uncertain environment they operate and how that might affect NPV.

Once they have done these predictions, management can decide if it is worthwhile investing more time and effort in understanding the uncertainty and trying to resolve it.


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Some “What If” Questions• Introduction

There are five methods managers use to handle project uncertainty:Sensitivity AnalysisScenario AnalysisSimulation AnalysisBreak-Even AnalysisOperating Leverage Analysis


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Some “What If” Questions• Sensitivity Analysis

A sensitivity analysis calculates the consequences of incorrectly estimating a variable in your NPV analysis.

If forces you: To identify the variables underlying your analysis. To focus on how changes to these variables could

impact the expected NPV. To consider what additional information should be

collected to resolve uncertainties about the variables.


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Some “What If” Questions


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Some “What If” Questions•Sensitivity Analysis

For example, if the initial investment in the project were $6.2 million, instead of $5.4 m, you would recalculate NPV as:

NPV = PV of Cash Flows - Investment (C0)

= [$806,667 x 12 year annuity factor] - 6.2 m= [$806,667 x 7.536] – 6.2 m= -$120,897 *

* Don’t forget to change the depreciation for the project!


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Some “What If” Questions• Sensitivity Analysis• You now know how badly the project could be thrown off

course by changes in certain variables.• Looking at the previous table, can you answer following

questions: What is the least critical variable to the success of the project? What are two most critical variables to the success of the project?

• You can see that the principal uncertainties come from sales and variable costs, under pessimistic assumptions, NPV could be significantly negative

If your sales are $14 mil. instead of $16 mil. the NPV is -$1.2 mil. If your variable costs are set at 83% if sales, NPV is -$0.8 mil.

• Fixed costs is the least critical variable, even the pessimistic assumption would lead to a positive NPV


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Some “What If” Questions• Sensitivity Analysis• Now that you have identified the critical success/failure factors, you

may wish to focus your attention on them: You might collect additional data on sales and costs so as to resolve

some of the uncertainty concerning these variables• Sensitivity analysis is not a “cure-all”. • It does have its drawbacks:

The results are ambiguous since the terms “optimistic” and “pessimistic” are completely subjective.

Variables are often related and it may be difficult to identify all of the consequences associated with a change in one of them.

• When variables are interrelated, it may be helpful to look at how the project would fare under different scenarios.

Scenario analysis allows us to look at different but consistent combinations of variables


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Some “What If” Questions• Simulation Analysis• A scenario analysis is helpful to see how interrelated variables impact

NPV. But one must run several hundred possible scenarios.• A simulation analysis uses a computer to generate hundreds, or even

thousands, of possible scenarios.• A probability distribution is assigned to each combination of variables

to create an entire range of potential outcomes.


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Break-Even Analysis• Accounting vs NPV Break-Even Analysis

A Break-Even analysis shows the level of sales at which a company “breaks even”. An accounting break-even occurs where total

revenues equal total costs (profits equal zero). A NPV break-even occurs when the NPV of the

project equals zero. Using accounting break-even can lead to poor

decisions. You can avoid this risk by using NPV break-even in

your analysis!


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Break-Even Analysis• Accounting Break-Even

Go back to the previous cash flow analysis you did : You estimated sales to be $16 million. Variable costs were 81.25% of sales ($0.8125 of variable

costs per $1 of sales). Fixed costs were $2 million and depreciation was $450,000.

Break-Even Revenues = Fixed Costs + Depreciation

Profit per $1 of Sales

= $2,000,000 + $450,000 = $2,450,000 = $13,066,667

$1 - $0.8125 $0.1875


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Creating an income statement at $13,066,667 of sales shows profit equals zero:

Revenues $13,066,667

Variable Costs 10,616,667

Fixed Costs + Depreciation 2,450,000

Pretax Profit 0

Taxes 0

Profit after Tax 0


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Break-Even Analysis•Accounting Break-Even

If a project breaks even in accounting terms is it an acceptable investment?

Clue: This project has a 12 year life …

Would you be happy with an investment which after 12 years gave you a zero

total rate of return?


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A project which simply breaks even on an accounting basis will always have a negative NPV!

Proof:

NPV = PV of Cash Flows – C0

= [$450,000 * (12 year Annuity Factor)] - $5.4 m $0

Note: the 12 year Annuity Factor 12 for all discount rates!

CFO= profit after tax + depreciation

= $0 + $450,000 = $450,000


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Break-Even Analysis

Note: Cash flow = Depreciation + After Tax Profit


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Break-Even Analysis• NPV Break-Even

This cash flow will last for 12 years.

But: NPV = 0 if PV (cash flows) = C0

NPV = 0 if (0.1125 x Sales – 1.02 m) x 7.536 = 5.4 m

Sales = $15.4 m

PV(cash flows) = Cash Flows x Annuity Factor

= (0.1125 x Sales - 1.02 m) x 12 year Annuity Factor

= (0.1125 x Sales - 1.02 m) x 7.536


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Break-Even Analysis•NPV Break-Even

Using the accounting break-even, the project had to generate sales of $13.067 million to have zero profit.

Using the NPV break-even, we find that the project needs sales of $15.4 million to have a zero NPV. The project needs to be 18% more successful to

break-even on a NPV basis!


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OPERATING LEVERAGE

• The Operating Leverage is the degree to which costs are fixed.

• The Degree of Operating Leverage (DOL) is the % change in profits given a 1% change in sales.

If DOL = 1, then a 1% change in sales will produce a 1% change in profits. This is a stable condition.

If DOL =50, then a 1% change in sales will produce a 50% change in profits. This is very volatile and thus very risky!.

Profits

on)Depreciati (Including Costs Fixed1

salesin change %

profitin change %DOL


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OPERATING LEVERAGE


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OPERATING LEVERAGE

In other words, high DOL means high risk if sales do not work out as forecasted!


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Flexibility in Capital Budgeting• The Value of Having Options

No matter how much analysis you do on a project, it is impossible to completely eliminate uncertainty.

A firm must have the option: To mitigate the effect of unpleasant surprises and to take advantage of pleasant ones?

Because the future is uncertain, successful financial managers seek to build flexibility into a project.

The perfect project would have: The option to expand if things go well. The option to bail out or switch production if things go poorly. The option to postpone if future conditions might improve.


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Flexibility in Capital Budgeting• The Value of Having Options

As a general rule, flexibility will be most valuable to you when the future is most uncertain.

The ability to change course as events develop and new information becomes available is most valuable when it is hard to predict with confidence what the best course of action will be.

Good outcomes can be exploited, while poor outcomes can be avoided or postponed.

Decision trees are used to diagram the options in a project.

You can then determine the optimal course of action from a series of potential options.

A decision tree is defined as a diagram of sequential decisions and their possible outcomes.


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Flexibility in capital Budgeting

= $1500.08


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Canadian Practices• Capital Budgeting Practices in Canadian Firms

A survey of the capital budgeting practices of large Canadian firms (In Table 8.7 on page 262), shows how Canadian firms are actually making capital budgeting decisions.

Most firms use multiple methods for analyzing a project’s acceptability.

Note that discounted cash flow techniques were used by more than 75% of respondents.

In most cases, IRR is more used than NPV The payback method is also common, particularly used in

conjunction with DFC methods For the cash flow forecasting, 39.5% use sensitivity analysis While 25% don’t use any risk analysis technique.

Documents

Semih Yildirim ADMS 3530 9-1 Chapter 9 Project Analysis Chapter Outline How Firms Organize the Investment Process Some “What If” Questions Break-Even