Fundamentals of Corporate Finance/3e,ch09

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

9-1

Chapter Nine

Project Analysis and Evaluation


9-2

9.1 Evaluating NPV Estimates

9.2 Scenario and Other ‘What If’ Analysis

9.3 Break-even Analysis

9.4 Operating Cash Flow, Sales Volume and Break-even

9.5 Operating Leverage

9.6 Additional Considerations in Capital Budgeting

9.7 Summary and Conclusions

Chapter Organisation


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Chapter Objectives• Understand and apply scenario analysis, sensitivity analysis

and simulation analysis to capital project evaluation.

• Apply break-even analysis, distinguishing between accounting break-even, cash break-even and financial break-even.

• Measure the degree of operating leverage of a firm.

• Discuss the various managerial options in capital budgeting.

• Outline capital rationing and the difference between soft and hard rationing.


9-4

Evaluating NPV Estimates

The basic problem: How reliable is our NPV estimate?

• Projected cash flows are based on a distribution of possible outcomes each period: resulting in an ‘average’ cash flow.

• Forecasting risk: the possibility of an incorrect decision due to errors in cash flow projections (GIGO system).

• Ask: What sources of value create the estimated NPV?


9-5

Scenario and Other ‘What If’ Analysis• Base case estimation

– Estimated NPV based on initial cash flow projections.

• Scenario analysis– Examine effect on NPV of best-case and worst-case

scenarios.

• Sensitivity analysis– Examine effect on NPV by changing only one input variable.

• Simulation analysis– Vary several input variables simultaneously to construct a

distribution of possible NPV estimates.


9-6

Fairways Driving Range Example

Fairways Driving Range expects annual rentals to be 20 000 buckets at $3 per bucket. Equipment costs $20 000 and is depreciated using the straight-line method over five years to a zero salvage value. Variable costs are 10 per cent of rentals income and fixed costs are $40 000 per year. Assume no increase in working capital and no additional capital outlays. The required rate of return is 15 per cent and the tax rate is 30 per cent.


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Fairways Example—Net Profit


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Fairways Example—Base Case NPV

• Estimated annual cash flow:

$10 000 + $4000 – $3000 = $11 000

• At 15%, the 5-year annuity factor is 3.3522.

• The base case NPV is then:

NPV = – $20 000 + ($11 000 × 3.3522)

= $16 874


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Fairways Example—Scenario Analysis

Inputs for scenario analysis:

Base case: Rentals are 20 000 buckets p.a., variable costs are 10 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a.

Best case: Rentals are 25 000 buckets p.a., variable costs are 8 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a.

Worst case: Rentals are 18 000 buckets p.a., variable costs are 12 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a.


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Fairways Example—Scenario Analysis


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Fairways Example—Sensitivity Analysis

Inputs for sensitivity analysis:

Base case: Rentals are 20 000 buckets p.a., variable costs are 10 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a.

Best case: Rentals are 25 000 buckets p.a. All other variables are unchanged.

Worst case: Rentals are 18 000 buckets p.a. All other variables are unchanged.


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Base case

NPV = $16 874

NPV

Worst case

NPV = $4 202

Rentals per Year

Best case

NPV = $48 552

0

–$60 00015 000

25 00020 000

$60 000

x

x

x



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Break-even Analysis• Useful for analysing the relationship between sales volume

and profitability.

• Break-even point is the sales volume at which the present value of the project’s cash inflows and outflows are equal NPV = 0.

• Important distinction between variable costs and fixed costs.

• Accounting break-even is the sales volume that results in a zero net profit.


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Fixed and Variable Costs• There are two types of costs that are important in break-even

analysis: variable and fixed.

-Variable costs change when the quantity of output changes

-Total variable costs= quantity × cost per unit

-Fixed costs are constant, regardless of output, over some time period

-Total Costs = fixed + variable = FC + vQ

Example:

Your firm pays $3000 per month in fixed costs. You also pay $15

per unit to produce your product.

(Total cost if you produce 1000 units = 3000 + 15(1000) = 18 000)

(Total cost if you produce 5000 units = 3000 + 15(5000) = 78 000)


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Average versus Marginal Cost• Average Cost

- TC/number of units

- Will decrease as number of units increases

• Marginal Cost

- The cost to produce one more unit

- Same as variable cost per unit

• Example: What is the average cost and marginal cost under each situation in the previous example?

- Produce 1000 units: Average = 18 000/1000 = $18

- Produce 5000 units: Average = 78 000/5000 = $15.60


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Fairways Example—Accounting Break-even Analysis

ndep' cost fixed cost variable costs accounting Total

cost fixed cost variablecost Total


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Accounting

break-even point

16 296 buckets

Rentals per Year

$50 000

$20 00015 000

25 000

$80 000

Total revenues

Fixed costs

+ Dep’n =

$44 000Net

Income < 0

Net

Income > 0

20 000

Total accounting

costs



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buckets 296 16

$0.30$3.00

$4000000 $40

unitper cost Variableunitper Price

onDepreciatiFCcosts Fixed

v P

D Q

Solve algebraically for break-even quantity (Q):

If sales do not reach 16 296 buckets, Fairways will incur losses in both the accounting sense and the financial sense.


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Accounting of Break-even Point

General expression

Q = (FC + D)/(P – v)

where:

Q = total units sold

FC = total fixed costs

D = depreciation

P = price per unit

v = variable cost per unit


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Using Accounting Break-even• Accounting break-even is often used as an early-

stage screening number.

• If a project cannot break even on an accounting basis, then it is not going to be a worthwhile project.

• Accounting break-even gives managers an indication of how a project will impact accounting profit.


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Summary of Break-even Measures

• Accounting break-even– Q = (FC + D)/(P – v)– At accounting break-even, net income = 0, NPV is negative

and IRR =0.• Cash break-even

– Q = FC/(p – v)– At cash break-even, OCF = 0, NPV is negative and IRR = –

100%.• Financial break-even

– Q = (FC + OCF)/(P – v)– At financial break-even, NPV = 0 and IRR = required return.


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Fairways Example—Break-even Measures

0 NPV 15% IRR

units 024 17 $0.30 $3.00

$5966 000 $40 even -break Financial

000 $20 NPV 100% IRR

units 815 14 $0.30 $3.00

000 $40 even -breakCash

591 $6 NPV 0 IRR

units 296 16 $0.30 $3.00

$4000 000 $40 even -break Accounting


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Operating Leverage• The degree to which a firm is committed to its fixed costs.• The higher the degree of operating leverage, the greater the

danger from forecasting risk.• The lower the degree of operating leverage, the lower the

break-even point.

• DOL depends on the current sales level.

OCF

FC1DOL

in %DOLOCFin %

Q


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Fairways Example—DOL

• Let Q = 20 000 buckets and, ignoring taxes, OCF = $14 000 and FC = $40 000.

• A 10 per cent increase (decrease) in quantity sold will result in a 38.57 per cent increase (decrease) in OCF.

• Note: Higher DOL equals greater volatility (risk) in OCF and leverage is a two-edged sword—sales decreases will be magnified as much as increases.

3.857 000 $14

000 $40 1 DOL


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Managerial Options and Capital Budgeting• A static DCF analysis ignores management’s ability to

modify the project as events occur.

• Contingency planning– The option to expand.– The option to abandon.– The option to wait.

• Strategic options– ‘Toe hold’ investments.– Research and development.


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Capital Rationing

• A condition which prevents management from undertaking all acceptable projects because of a shortage of funds.

• Soft rationing occurs when management limits the amount that can be invested in new projects during some specified time period.

• Hard rationing occurs when the firm is unable to raise the financing for a project.

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