Chapter 9

1. Chapter 9 • 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 Project Analysis Semih Yildirim ADMS 3530

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. • This “wish list” must then be examined to determine which projects should go forward. • Capital budgeting is a cooperative effort with some challenges: • 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

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

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

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

6. Some “What If” Questions Semih Yildirim ADMS 3530

7. Some “What If” Questions Semih Yildirim ADMS 3530

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

9. Some “What If” Questions • Sensitivity 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: • What is the least critical variable to the success of the project? • What are two most critical variables to the success of the project? • You can see that the principal uncertainties come from sales and variable costs, under pessimistic assumptions, NPV could be significantly negative • 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

10. Some “What If” Questions • Sensitivity Analysis • 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: • 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

11. Some “What If” Questions Semih Yildirim ADMS 3530

12. 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. Semih Yildirim ADMS 3530

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

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=$2,450,000 = $13,066,667 $1 - $0.8125 $0.1875 Semih Yildirim ADMS 3530

15. 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 10,616,667 Fixed Costs + Depreciation 2,450,000 Pretax Profit 0 Taxes 0 Profit after Tax 0 Semih Yildirim ADMS 3530

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

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! Semih Yildirim ADMS 3530

18. Break-Even Analysis Note: Cash flow = Depreciation + After Tax Profit Semih Yildirim ADMS 3530

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 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 Semih Yildirim ADMS 3530

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

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. • 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

22. OPERATING LEVERAGE Semih Yildirim ADMS 3530

23. OPERATING LEVERAGE In other words, high DOL means high risk if sales do not work out as forecasted! Semih Yildirim ADMS 3530

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

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

26. Flexibility in capital Budgeting = $1500.08 Semih Yildirim ADMS 3530

27. Canadian Practices • Capital Budgeting Practices in Canadian Firms • 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