7.Project Analysis

Chapter 6Project Analysis and Evaluation

Dr. Agim Mamuti

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

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Chapter Organisation9.1 9.2 9.3 9.4 9.5 9.6 9.7 Evaluating NPV Estimates Scenario and Other What If Analysis Break-even Analysis Operating Cash Flow, Sales Volume and Break-even Operating Leverage Additional Considerations in Capital Budgeting Summary and Conclusions


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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.


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Evaluating NPV EstimatesThe 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?


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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.9-5


Fairways Driving Range ExampleFairways 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 ExampleNet Profit


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Fairways ExampleBase 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 ExampleScenario AnalysisInputs 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 ExampleScenario Analysis


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Fairways ExampleSensitivity AnalysisInputs 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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Fairways ExampleSensitivity Analysis


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Fairways ExampleSensitivity AnalysisNPV $60 000 Base case NPV = $16 874 Worst case 0 NPV = $4 202 Best case NPV = $48 552

x

x

x

$60 000

15 000

20 000

25 000

Rentals per YearCopyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

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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 projects 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 sometime period

-Total Costs = fixed + variable = FC + vQExample: 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 2004 you produce 5000 Ltd Copyrightcost ifMcGraw-Hill Australia Pty units = 3000 + 15(5000) = 78 000)PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

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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 = $15.609-16


Fairways ExampleAccounting Break-even AnalysisTotal cost = variable cost + fixed cost Total accounting costs = variable cost + fixed cost + dep' n


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Fairways ExampleAccounting Break-even AnalysisTotal revenues $80 000 Accounting break-even point 16 296 buckets $50 000 Total accounting costs

Fixed costs + Depn = Net Income < 0 Net Income > 0 $44 000

$20 000 15 000

20 000 Rentals per Year

25 000


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Fairways ExampleAccounting Break-even AnalysisSolve algebraically for break-even quantity (Q):

( Fixed costs ( FC) + Depreciati on ( D ) ) Q= ( Price per unit ( P ) Variable cost per unit ( v ) ) ( $22 2 $2222 ) 2 + 2 = ( $222$222 . . )= 2 22 2 2 bucketsIf sales do not reach 16 296 buckets, Fairways will incur losses in both the accounting sense and the financial sense.Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

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Accounting of Break-even PointGeneral expression Q = (FC + D)/(P v) where: Q FC D P v = total units sold = total fixed costs = depreciation = price per unit = 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, Operating Cash Flow 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 ExampleBreak-even Measures( $22 2 $22222 2 units ) = 2 22 2 + 2 Accounting break - even = ( $2 $2 ) .22 .22IRR = 2 Cash break - even = NPV = $2 2 22 $22 2 2 2 = 2 22 2 2 units ( $2 $2 ) .22 .22 IRR = 22 NPV = $22 2 2% 2 2

Financial break - even =

( $22 2 $0000 00 ) = 0 0 units 2 + 2 0 ( $2 $0 ) .22 .00NPV = 29-23

IRR = 2% 2Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

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 (DOL), the lower the break-even point.

% in OCF = DOL % in Q FC DOL = 2 + OCF

DOL depends on the current sales level.9-24


Fairways ExampleDOL

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

$22 2 2 2 DOL = 2 + =22 .22 $22 2 2 2

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 swordsales decreases will be magnified as much as increases.


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Managerial Options and Capital Budgeting A static Discounted Cash Flow (DCF) analysis

ignores managements 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.9-26

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.Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

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7.Project Analysis

Documents

jordan slides

hill australia

fairways exampleaccounting

capital budgeting

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cash break

sales volume

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