Fundamentals of Corporate Finance: Second Canadian Edition

8-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright 2003 McGraw Hill Ryerson Limited

8-2
Chapter 8
Project Analysis
Chapter Outline
How Firms Organize the Investment
Process
Some What If Questions
Break-Even Analysis
Flexibility in Capital Budgeting
Capital Budgeting Practices in Canadian
Firms

8-3
The Investment Decision

How Firms Organize the Investment Process
Once a year, a firms 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 known as the
capital budget.
This wish list must then be examined to determine
which projects should go forward.
How is this done?

8-4

Introduction
Managers want to understand more
than the NPV of a project.
They also want to predict what events
could happen and how that might affect
NPV.
Once they have done this, management
can decide if it is worthwhile investing more
time and effort in understanding the
uncertainty and trying to resolve it.
8-5

Introduction
There are five methods managers use
to handle project uncertainty:
Sensitivity
Analysis
Scenario Analysis
Simulation Analysis
Break-Even Analysis
Operating Leverage Analysis

8-6

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.

8-7

Suppose, as a financial manager, you have
estimated the cash flow forecasts for a new
grocery store.
These are shown on on the next slide.
The project has a positive NPV of $478,000.
Before you recommend the project to your
boss, you want to analyze the forecast and
identify the key variables which will determine
whether the project succeeds or fails.
8-8

Cash Flow Forecasts: Year 0 Years 1-12
Investment ($5,400)
Sales $16,000
Variable Costs (81.25% of Sales) 13,000
Fixed Costs 2,000
Depreciation (Straight Line) 450
Pretax Profit 550
Taxes @ 40% 220
Profit after Tax 330
Cash Flow from Operations 780
Net Cash Flow ($5,400) $780
8-9

You want to look at how the NPV of the
project may be affected by an incorrect
forecast of sales, costs, etc.
You develop the optimistic and
pessimistic estimates for the underlying
variables which are shown on the next
slide.

8-10

You will use the estimates below, one at time,
to recalculate NPV:
Range in dollars
Variable: Optimistic Expected Pessimistic
Investment $6,200 $5,400 $5,000
Sales $14,000 $16,000 $18,000
Variable Costs as a % of Sales 83.00% 81.25% 80.00%
Fixed Costs $2,100 $2,000 $1,900
8-11

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 *
* Dont forget to change the depreciation for the project!

8-12

After all the recalculations, you would have
the following estimates:
NPV in dollars
Variable: Optimistic Expected Pessimistic
Investment ($121,000) $478,000 $778,000

Sales ($1,218,000) $478,000 $2,174,000
Variable Costs as a % of Sales ($788,000) $478,000 $1,382,000
Fixed Costs $26,000 $478,000 $930,000
8-13

You now know how badly the project could be
thrown off course by changes in certain
variables.
Looking at the table on the previous slide, can
you answer the following questions:
What is the least critical variable to the success of
the project?
What are the two most critical variables to the
success of the project?

8-14

Did you identify fixed costs as the least critical
variable?
Even under the pessimistic assumption about fixed
costs, the project has a positive NPV, so it is
unlikely to give you trouble if you have estimated it
incorrectly.
Did you identify sales and variable costs as
the most critical variables?
A poor estimate of either of these could lead to a
significantly negative NPV for the project.

8-15

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.

8-16

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.

8-17

Scenario Analysis
A scenario analysis involves changing
several variables at once in your NPV
forecast.
See Example 8.2

8-18

Simulation Analysis
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.

8-19
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!

8-20
Break-Even Analysis
Accounting Break-Even
An accounting break-even occurs where
total revenues equal total costs, and thus
profits are zero.
How do we calculate this point?

8-21
Break-Even Analysis
Go back to the cash flow analysis you did on
Slide #8:
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.
These variables are all you need to calculate
accounting break-even!

8-22
Break-Even Analysis
Accounting break-even is calculated as:
Break-Even Revenues = Fixed Costs + Depreciation
Profit per $1 of Sales
= $2,000 + $450
$1 - $0.8125
= $2,450
$0.1875
= $13.067 million
8-23
Break-Even Analysis
Creating an income statement at $13.067
million of sales shows profit equals zero:
Revenues $13,067
Variable Costs 10,067
Fixed Costs + Depreciation 2,450
Pretax Profit 0
Taxes 0
Profit after Tax 0
8-24
Break-Even Analysis
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?

8-25
Break-Even Analysis
A project which simply breaks even on an
accounting basis will always have a negative NPV!
Proof:
CFO = profit after tax + depreciation
= $0 + $450,000 = $450,000
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!

8-26
Break-Even Analysis
NPV Break-Even
Asking how bad sales can get before a
project makes an accounting loss is not the
best tool for analysis of a project.
Instead, it is more useful to focus on the
point at which NPV switches from negative

to positive.
Lets develop a method for calculating this
NPV break-even!
8-27
Break-Even Analysis
NPV Break-Even
Going back to our example:
Variable Costs 81.25% of Sales
+ Fixed Costs + Depreciation $2.45 m
Pretax Profit (0.1875 Sales) - 2.45 m
- Tax @ 40% 0.40 x [(0.1875 Sales) - 2.45 m]
After Tax Profit 0.60 x [(0.1875 Sales) - 2.45 m]
Cash flow $0.45 m + 0.60 x [(0.1875 Sales) - 2.45 m]
= 0.1125 * Sales - $1.02 m
Note: Cash flow = Depreciation + After Tax Profit
8-28
Break-Even Analysis
NPV Break-Even
This cash flow will last for 12 years.
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
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
8-29
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.
Theproject needs to be 18% more successful to
break-even on a NPV basis!

8-30
Break-Even Analysis
Degree of Operating Leverage (DOL)
Lets say you are predicting a 1% change in
the sales of your firm.
How will that change affect your firms profits?
1) A 1% change in sales could lead to a 1%
change in profits.
This would be a very stable situation.
2) Or, it could lead to a 50% change in profits.
This would be a very risky and volatile
situation.

8-31
Break-Even Analysis
Operating leverage is a measure of the
percentage of a firms costs that are fixed.
measures the percentage 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.
If DOL = 50, then a 1% change in sales will
produce a 50% change in profits.

8-32
Break-Even Analysis
There are two ways of measuring DOL:
DOL = percentage change in profits
percentage change in sales
DOL = 1 + fixed costs

profits
Note that the level of fixed costs in a company will

determine DOL and how volatile its profits are in
response to a change in sales.

8-33
Break-Even Analysis
If you examine Table 8.4 on page 256, you
will see that the risk of a project is affected
by its DOL.
If a large proportion of the projects costs are
fixed, then DOL will be high.
If DOL is high, then any shortfall in sales will
have a magnified effect on profits.
In other words, high DOL means high risk
if sales do not work out as forecasted!

8-34

The Value of Having Options
No matter how much analysis you do on
a project, it is impossible to completely
eliminate uncertainty.
Can you think of any way:
To mitigate the effect of unpleasant surprises.

and
To take advantage of pleasant ones?

8-35

Because the future is uncertain, successful
financial managers seek projects with
flexibility.
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.

8-36

Options
to avoid a loss, switch production or abandon
a project;
to expand and produce extra profit; or
to postpone action
have significant value for a firm.

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

8-37

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.
Figure 8.3 is an example of a decision tree.

8-38

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.
8-39
Canadian Practices
Capital Budgeting Practices in Canadian
Firms
In Table 8.7 on page 262, you can see how
Canadian firms are actually making capital
budgeting decisions.
Most firms use multiple methods for analyzing
a projects acceptability.
Note that discounted cash flow techniques
were used by more than 75% of respondents.

8-40
Summary of Chapter 8
Successful managers know that the
forecasts behind NPV calculations are
imperfect.
Thus, they explore the consequences to
the firm of a poor forecast.
They check whether the project is really
worth pursuing by doing some additional
homework.
This consists of asking a series of what-if
questions to determine the feasibility of the
project and its risk profile.

8-41
The principal tools used by managers in
what-if questions are:
Sensitivity
Analysis
Scenario Analysis
Simulation Analysis
Break-Even Analysis
Operating Leverage
A desirable characteristic in a project is

flexibility.

8-42
Projects with options to expand,
abandon, switch production, or
postpone actions may have added value
to the firm.
You can use decision trees to analyze
such flexibility.
A survey of Canadian firms shows that
most use multiple capital budgeting
methods to assess projects.

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8-1

copyright 2003 McGraw Hill Ryerson Limited

copyright 2003 McGraw Hill Ryerson Limited

The Investment Decision

How is this done?

copyright 2003 McGraw Hill Ryerson Limited

Some What If Questions

Some What If Questions

Operating Leverage Analysis

copyright 2003 McGraw Hill Ryerson Limited

Some What If Questions

copyright 2003 McGraw Hill Ryerson Limited

Some What If Questions

Some What If Questions

Some What If Questions

copyright 2003 McGraw Hill Ryerson Limited

Some What If Questions

Some What If Questions

copyright 2003 McGraw Hill Ryerson Limited

Some What If Questions

Variable: Optimistic Expected Pessimistic

Investment ($121,000) $478,000 $778,000

Some What If Questions

copyright 2003 McGraw Hill Ryerson Limited

Some What If Questions

copyright 2003 McGraw Hill Ryerson Limited

Some What If Questions

copyright 2003 McGraw Hill Ryerson Limited

Some What If Questions

copyright 2003 McGraw Hill Ryerson Limited

Some What If Questions

copyright 2003 McGraw Hill Ryerson Limited

Some What If Questions

copyright 2003 McGraw Hill Ryerson Limited

copyright 2003 McGraw Hill Ryerson Limited

copyright 2003 McGraw Hill Ryerson Limited

copyright 2003 McGraw Hill Ryerson Limited

Would you be happy with an investment

copyright 2003 McGraw Hill Ryerson Limited

copyright 2003 McGraw Hill Ryerson Limited

point at which NPV switches from negative

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

project needs sales of $15.4 million to have

copyright 2003 McGraw Hill Ryerson Limited

copyright 2003 McGraw Hill Ryerson Limited

copyright 2003 McGraw Hill Ryerson Limited

DOL = 1 + fixed costs

Note that the level of fixed costs in a company will

copyright 2003 McGraw Hill Ryerson Limited

copyright 2003 McGraw Hill Ryerson Limited

Flexibility in Capital Budgeting

To mitigate the effect of unpleasant surprises.

copyright 2003 McGraw Hill Ryerson Limited

Flexibility in Capital Budgeting

The option to expand if things go well.

copyright 2003 McGraw Hill Ryerson Limited

Flexibility in Capital Budgeting

have significant value for a firm.

copyright 2003 McGraw Hill Ryerson Limited

Flexibility in Capital Budgeting

copyright 2003 McGraw Hill Ryerson Limited

Flexibility in Capital Budgeting

copyright 2003 McGraw Hill Ryerson Limited