Download Project Analysis

9-1
Chapter 9
Project Analysis
Chapter Outline
How Firms Organize the Investment
Process
 Some “What If” Questions
 Break-Even Analysis
 Real Options and the Value of Flexibility
 Capital Budgeting Practices in Canadian
Firms

Semih Yildirim
ADMS 3530
9-2
The Investment Decision
•
How Firms Organize the Investment Process


Once a year, a firm’s 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 called the capital budget.


Capital budgeting is a cooperative effort with some challenges:




This “wish list” must then be examined to determine which projects
should go forward.
Forecasts from divisions must be consistent
Conflicts of interests must be eliminated
Forecast bias must be reduced
Senior management must look behind NPVs and understand
why they are positive or negative.
Semih Yildirim
ADMS 3530
9-3
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.
Semih Yildirim
ADMS 3530
9-4
Some “What If” Questions
• Introduction

There are five methods managers use
to handle project uncertainty:
 Sensitivity
Analysis
 Scenario Analysis
 Simulation Analysis
 Break-Even Analysis
 Operating Leverage Analysis
Semih Yildirim
ADMS 3530
9-5
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.
Semih Yildirim
ADMS 3530
9-6
Some “What If” Questions
Semih Yildirim
ADMS 3530
9-7
Some “What If” Questions
Semih Yildirim
ADMS 3530
9-8
Some “What If” Questions
• Sensitivity Analysis

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 *
* Don’t forget to change the depreciation for the project!
Semih Yildirim
ADMS 3530
Some “What If” Questions
• Sensitivity
9-9
Analysis
•
You now know how badly the project could be thrown off
course by changes in certain variables.
• Looking at the previous table, can you answer following
questions:


•
You can see that the principal uncertainties come from
sales and variable costs, under pessimistic assumptions,
NPV could be significantly negative


•
What is the least critical variable to the success of the project?
What are two most critical variables to the success of the project?
If your sales are $14 mil. instead of $16 mil. the NPV is -$1.2 mil.
If your variable costs are set at 83% if sales, NPV is -$0.8 mil.
Fixed costs is the least critical variable, even the
pessimistic assumption would lead to a positive NPV
Semih Yildirim
ADMS 3530
9-10
Some “What If” Questions
• Sensitivity
•
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
Sensitivity analysis is not a “cure-all”.
It does have its drawbacks:


•
Analysis
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.
When variables are interrelated, it may be helpful to look at how the
project would fare under different scenarios.

Scenario analysis allows us to look at different but consistent
combinations of variables
Semih Yildirim
ADMS 3530
9-11
Some “What If” Questions
Semih Yildirim
ADMS 3530
Some “What If” Questions
9-12
•
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.
•
•
Semih Yildirim
ADMS 3530
9-13
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!
Semih Yildirim
ADMS 3530
9-14
Break-Even Analysis
•
Accounting Break-Even

Go back to the previous cash flow analysis you did :



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 =
$13,066,667
$0.1875
Semih Yildirim
ADMS 3530
9-15
Break-Even Analysis
• Accounting

Break-Even
Creating an income statement at $13,066,667
of sales shows profit equals zero:
Revenues
Variable Costs
Fixed Costs + Depreciation
$13,066,667
10,616,667
2,450,000
Pretax Profit
0
Taxes
0
Profit after Tax
0
Semih Yildirim
ADMS 3530
9-16
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?
Semih Yildirim
ADMS 3530
9-17
Break-Even Analysis
• Accounting
Break-Even
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!
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ADMS 3530
9-18
Break-Even Analysis
Note: Cash flow = Depreciation + After Tax Profit
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ADMS 3530
9-19
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
 NPV = 0
if
if
PV (cash flows) = C0
(0.1125 x Sales – 1.02 m) x 7.536 = 5.4 m
 Sales = $15.4 m
Semih Yildirim
ADMS 3530
9-20
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!
Semih Yildirim
ADMS 3530
9-21
OPERATING LEVERAGE
•
The Operating Leverage is the degree to which costs
are fixed.
• The Degree of Operating Leverage (DOL) is the %
change in profits given a 1% change in sales.
% change in profit
Fixed Costs (Including Depreciati on)
DOL 
 1
% change in sales
Profits


If DOL = 1, then a 1% change in sales will produce a 1% change in
profits. This is a stable condition.
If DOL =50, then a 1% change in sales will produce a 50% change in
profits. This is very volatile and thus very risky!.
Semih Yildirim
ADMS 3530
9-22
OPERATING LEVERAGE
Semih Yildirim
ADMS 3530
9-23
OPERATING LEVERAGE
In other words, high DOL means high risk if sales
do not work out as forecasted!
Semih Yildirim
ADMS 3530
9-24
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.



Semih Yildirim
ADMS 3530
9-25
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.
 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.
Semih Yildirim
ADMS 3530
9-26
Flexibility in capital Budgeting
= $1500.08
Semih Yildirim
ADMS 3530
9-27
Canadian Practices
•
Capital Budgeting Practices in Canadian Firms
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A survey of the capital budgeting practices of large Canadian
firms (In Table 8.7 on page 262), shows how Canadian firms are
actually making capital budgeting decisions.
Most firms use multiple methods for analyzing a project’s
acceptability.
Note that discounted cash flow techniques were used by more
than 75% of respondents.
In most cases, IRR is more used than NPV
The payback method is also common, particularly used in
conjunction with DFC methods
For the cash flow forecasting, 39.5% use sensitivity analysis
While 25% don’t use any risk analysis technique.
Semih Yildirim
ADMS 3530