Project Analysis

Session 5

Investment Process
STAGE 1: THE CAPITAL BUDGET STAGE 2: PROJECT AUTHORIZATIONS PROBLEMS AND SOME SOLUTIONS

Ensuring that Forecasts Are Consistent Eliminating Conflicts of Interest Reducing Forecast Bias Sorting the Wheat from the Chaff

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.

Some What If Questions

Introduction

There are four methods managers use to handle project uncertainty:

Sensitivity Analysis Scenario Analysis Simulation Analysis Break-Even Analysis

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.

Some What If Questions

Finefodder is considering opening a new superstore. Cost of Capital 8%

NPV = 478,000

PV = $780,000 12-year annuity factor = $780,000 7.536 = $5.878 million NPV = PV investment = $5.878 million $5.4 million = $478,000

Some What If Questions

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.

Sensitivity Analysis v/s Scenario Analysis

Sensitivity Analysis v/s Scenario Analysis

Both calculate how NPV depends on input assumptions Sensitivity analysis changes inputs one at a time

Scenario analysis changes several variables at once

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!

Break-Even Analysis

Accounting Break-Even 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

$1 - $0.8125

$2,450,000 $0.1875

$13,066,667

Break-Even Analysis

Accounting Break-Even

Creating an income statement at $13,066,667 of sales shows profit equals zero: Revenues $13,066,667 Variable Costs (81.25% of sales)10,616,667 Fixed Costs + Depreciation 2,450,000 Pretax Profit 0 Taxes 0 Profit after Tax 0

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?

Break-Even Analysis

Accounting Break-Even

A project which simply breaks even on an accounting

basis will always have a negative NPV! Proof:

Operating Cashflow = profit after tax + depreciation = $0 + $450,000 = $450,000 The initial investment is $5.4m. In each of the next 12 years, firm receives a cashflow of $450,000. So firm gets its money back Total operating cashflow= initial investment = 12*$450,000=$5.4m

But revenues are not sufficient to repay the opportunity cost of that $5.4 million investment. NPV is negative.

Break-Even Analysis

Note: Cash flow = Depreciation + After Tax Profit

Break-Even Analysis

NPV Break-Even
This cash flow will last for 12 years. So to find its present value we multiply by the 12-year annuity factor. With a discount rate of 8 percent, the present value of $1 a year for each of 12 years is $7.536. Thus the present value of the cash flows is

PV (cash flows) = 7.536 (.1125 sales $1.02 million) PV (cash flows) = investment 7.536 (.1125 sales $1.02 million) = $5.4 million $7.69 million + .8478 sales = $5.4 million Sales = 5.4 + 7.69 / .8478 Sales = 15.4 million

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!

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.

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.

Flexibility in Capital Budgeting

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.

Example of Decision Tree

Squares represent decisions to be made. Circles represent A receipt of information e.g. a Study test score. B finance C Do not study

D
F

The lines leading away from the squares represent the alternatives.