Chapters Outline Prepared by: Thomas J. Cottrell Modified by: Carlos Vecino HEC-Montreal Chapter 9 Net Present Value and Other Investment Criteria 9.1Net.

Chapters Outline

Prepared by: Thomas J. CottrellModified by: Carlos Vecino HEC-Montreal

Chapter 9Net Present Value and Other Investment Criteria

9.1 Net Present Value

Chapter 10Making Capital Investment Decisions

10.1 Project Cash Flows: A First Look

10.2 Incremental Cash Flows

10.3 Pro Forma Financial Statements and Project Cash Flows

Chapter 11Project Analysis and Evaluation

11.3 Break-Even Analysis 11.4 Operating Cash Flow, Sales Volume, and Break-Even 11.5 Operating Leverage

Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd.

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 2

NPV Illustrated

Assume you have the following information on Project X:

Initial outlay -$1,100 Required return = 10%

Annual cash revenues and expenses are as follows:

Year Revenues Expenses

1 $1,000 $500

2 2,000 1,000

Draw a time line and compute the NPV of project X.


NPV Illustrated (concluded)

0 1 2

Initial outlay($1,100)

Revenues $1,000Expenses 500

Cash flow $500

Revenues $2,000Expenses 1,000

Cash flow $1,000

– $1,100.00

+454.55

+826.45

+$181.00

1$500 x 1.10

1$1,000 x 1.10

2

NPV


Underpinnings of the NPV Rule

Why does the NPV rule work? And what does “work” mean? Look at it this way:

A “firm” is created when securityholders supply the funds to acquire assets that will be used to produce and sell a good or a service;

The market value of the firm is based on the present value of the cash flows it is expected to generate;

Additional investments are “good” if the present value of the incremental expected cash flows exceeds their cost;

Thus, “good” projects are those which increase firm value - or, put another way, good projects are those projects that have positive NPVs!

Moral of the story: Invest only in projects with positive NPVs.


Fundamental Principles of Project Evaluation

Fundamental Principles of Project Evaluation:

Project evaluation - the application of one or more capital budgeting decision rules to estimated relevant project cash flows in order to make the investment decision.

Relevant cash flows - the incremental cash flows associated with the decision to invest in a project.

The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash

flows that are a direct consequence of taking the project.

Stand-alone principle - evaluation of a project based on the project’s incremental cash flows.


Example: Preparing Pro Forma Statements

Suppose we want to prepare a set of pro forma financial statements for a project for Norma Desmond Enterprises. In order to do so, we must have some background information. In this case, assume:

1. Sales of 10,000 units/year @ $5/unit.

2. Variable cost per unit is $3. Fixed costs are $5,000 per year. The project has no salvage value. Project life is 3 years.

3. Project cost is $21,000. Depreciation is $7,000/year.

4. Additional net working capital is $10,000.

5. The firm’s required return is 20%. The tax rate is 34%.


Example: Preparing Pro Forma Statements (continued)

Pro Forma Financial Statements

Projected Income Statements

Sales $______

Var. costs ______

$20,000

Fixed costs 5,000

Depreciation 7,000

EBIT $______

Taxes (34%) 2,720

Net income $______


Example: Preparing Pro Forma Statements (continued)

Pro Forma Financial Statements

Projected Income Statements

Sales $50,000

Var. costs 30,000

$20,000

Fixed costs 5,000

Depreciation 7,000

EBIT $ 8,000

Taxes (34%) 2,720

Net income $ 5,280


Example: Preparing Pro Forma Statements (concluded)

Projected Balance Sheets

0 1 2 3

NWC $______ $10,000 $10,000 $10,000

NFA 21,000 ______ ______ 0

Total $31,000 $24,000 $17,000 $10,000


Example: Preparing Pro Forma Statements (concluded)

Projected Balance Sheets

0 1 2 3

NWC $10,000 $10,000 $10,000 $10,000

NFA 21,000 14,000 7,000 0

Total $31,000 $24,000 $17,000 $10,000


Example: Using Pro Formas for Project Evaluation

Now let’s use the information from the previous example to do a capital budgeting analysis.

Project operating cash flow (OCF):

EBIT $8,000

Depreciation +7,000

Taxes -2,720

OCF $12,280


Example: Using Pro Formas for Project Evaluation (continued)

Project Cash Flows

0 1 2 3

OCF $12,280 $12,280 $12,280

Chg. NWC ______ ______

Cap. Sp. -21,000

Total ______ $12,280 $12,280 $______


Example: Using Pro Formas for Project Evaluation (continued)

Project Cash Flows

0 1 2 3

OCF $12,280 $12,280 $12,280

Chg. NWC -10,000 10,000

Cap. Sp. -21,000

Total -31,000 $12,280 $12,280 $22,280


Example: Using Pro Formas for Project Evaluation (concluded)

Capital Budgeting Evaluation:

NPV = -$31,000 + $12,280/1.201 + $12,280/1.20 2 + $22,280/1.20

3

= $655

IRR = 21%

Should the firm invest in this project? Why or why not?

Yes -- the NPV > 0, and the IRR > required return


Evaluating NPV Estimates I: The Basic Problem

The basic problem: How reliable is our NPV estimate? Projected vs. Actual cash flows

Estimated cash flows are based on a distribution of possible outcomes each period

Forecasting risk

The possibility of a bad decision due to errors in cash flow projections - the GIGO phenomenon

Sources of value

What conditions must exist to create the estimated NPV?

“What If” analysis

A. Scenario analysis

B. Sensitivity analysis


Evaluating NPV Estimates II: Scenario and Other “What-If” Analyses

Scenario and Other “What-If” Analyses “Base case” estimation

Estimated NPV based on initial cash flow projections

Scenario analysis

Posit best- and worst-case scenarios and calculate NPVs

Sensitivity analysis

How does the estimated NPV change when one of the input variables changes?

Simulation analysis

Vary several input variables simultaneously, then construct a distribution of possible NPV estimates


T11.12 Summary of Break-Even Measures (Table 11.1)

I. The General Expression

Q = (FC + OCF)/(P - V)

where: FC = total fixed costsP = Price per unitv = variable cost per unit

II. The Accounting Break-Even Point

Q = (FC + D)/(P - V)

At the Accounting BEP, net income = 0, NPV is negative, and IRR of 0.

III. The Cash Break-Even Point

Q = FC/(P - V)

At the Cash BEP, operating cash flow = 0, NPV is negative, and IRR = -100%.

IV. The Financial Break-Even Point

Q = (FC + OCF*)/(P - V)

At the Financial BEP, NPV = 0 and IRR = required return.


Fairways Driving Range Example

Fairways Driving Range expects rentals to be 20,000 buckets at $3 per bucket. Equipment costs $20,000 and will be depreciated using SL over 5 years and have a $0 salvage value. Variable costs are 10% of rentals and fixed costs are $40,000 per year. Assume no increase in working capital nor any additional capital outlays. The required return is 15% and the tax rate is 15%.

Revenues $60,000

Variable costs 6,000

Fixed costs 40,000

Depreciation 4,000

EBIT $10,000

Taxes (@15%) 1500

Net income $ 8,500


Fairways Driving Range Sensitivity Analysis

INPUTS FOR SENSITIVITY ANALYSIS

Base case: Rentals are 20,000 buckets, variable costs are 10% of revenues, fixed costs are $40,000, depreciation is $4,000 per year, and the tax rate is 15%.

Best case: Rentals are 25,000 buckets and revenues are $75,000. All other variables are unchanged.

Worst case: Rentals are 18,000 buckets and revenues are $54,000. All other variables are unchanged.


T11.6 Fairways Driving Range Sensitivity Analysis (concluded)

Net ProjectScenario Rentals Revenues income cash flow NPV

Best case 25,000 $75,000 $19,975 $23,975 $60,364

Base case 20,000 60,000 8,500 12,500 21,900

Worst case 18,000 54,000 3,910 7,910 6,514


Fairways Driving Range: Rentals vs. NPV

Fairways Sensitivity Analysis - Rentals vs. NPV

Base case

NPV = $21,900

NPV

Worst case

NPV = $3,437

Rentals per Year

Best case

NPV = $60,035

0

-$60,00015,000

25,00020,000

$60,000

x

x

x


Total Cost = Variable cost + Fixed cost

Variable Fixed Total TotalRentals Revenue cost cost cost Depr. acct. cost

0 $0 $0 $40,000 $40,000 $4,000 $44,000

15,000 45,000 4,500 40,000 44,500 4,000 48,500

20,000 60,000 6,000 40,000 46,000 4,000 50,000

25,000 75,000 7,500 40,000 47,500 4,000 51,500

Fairways Driving Range: Total Cost Calculations


Fairways Driving Range: Break-Even AnalysisFairways Break-Even Analysis - Sales vs. Costs and Rentals

Accounting

break-even point

16,296 Buckets

Rentals per Year

$50,000

$20,00015,000

25,000

$80,000

Total revenues

Fixed costs + Dep

$44,000

Net

Income < 0

Net

Income > 0

20,000


Fairways Driving Range: Accounting Break-Even Quantity

Fairways Accounting Break-Even Quantity (Q)

Q = (Fixed costs + Depreciation)/(Price per unit - Variable cost per unit)

= (FC + D)/(P - V)

= ($40,000 + 4,000)/($3.00 - .30)

= 16,296 buckets

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


Operating Leverage

Basic Idea: “Operating Leverage” is the degree to which a project or a firm relies on fixed production costs.

Measuring Operating Leverage: If the quantity sold rises by X%, what will be the percentage change in operating cash flow?This percentage change (%) in Operating Cash Flow (OCF) is called the Degree of Operating Leverage (DOL).

Percentage change (%) in OCF = DOL x Percentage change (%) in Q

DOL = 1 + (Fixed Costs / OCF)


Fairways Driving Range DOL

Since % in OCF = DOL % in Q, DOL is a “multiplier” which measures the effect of a change in quantity sold on OCF.

For Fairways, let Q = 20,000 buckets. Ignoring taxes,

OCF = $14,000 and fixed costs = $40,000, and

Fairway’s DOL = 1 + FC/OCF = 1 + $40,000/$14,000 = 3.857.

In other words, a 10% increase (decrease) in quantity sold will result in a 38.57% increase (decrease) in OCF.

Two points should be kept in mind: Higher DOL suggests greater volatility (i.e., risk) in OCF; Leverage is a two-edged sword - sales decreases will be

magnified as much as increases.

Chapters Outline Prepared by: Thomas J. Cottrell Modified by: Carlos Vecino HEC-Montreal Chapter 9 Net Present Value and Other Investment Criteria 9.1Net.

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