1 / 28

Chapter 11 Project Analysis and Evaluation

Chapter 11 Project Analysis and Evaluation. 11.1 Evaluating NPV Estimates 11.2 Scenario and Other “What-if” Analyses 11.3 Break-Even Analysis 11.4 Operating Cash Flow, Sales Volume, and Break-Even 11.5 Operating Leverage 11.6 Additional Considerations in Capital Budgeting

hartwell-carl
Download Presentation

Chapter 11 Project Analysis and Evaluation

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter 11Project Analysis and Evaluation • 11.1 Evaluating NPV Estimates • 11.2 Scenario and Other “What-if” Analyses • 11.3 Break-Even Analysis • 11.4 Operating Cash Flow, Sales Volume, and Break-Even • 11.5 Operating Leverage • 11.6 Additional Considerations in Capital Budgeting • 11.7 Summary and Conclusions Vigdis BoassonMgf301, School of Management, SUNY at Buffalo

  2. 11.2 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

  3. 11.3 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

  4. 11.4 Fairways Driving Range Example • Fairways Driving Range expects rentals to be 20,000 buckets at $3 per bucket. Equipment costs are $20,000 depreciated using SL over 5 years and have a $0 salvage value. Variable costs are 10% of rentals and fixed costs are $45,000 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 (20k x $3): $60,000 Variable Costs (.10 x 60k): 6,000 Fixed Costs: 45,000 Depreciation (20k /5yrs): 4,000 EBIT: 5,000 Taxes (@15%) 750 Net Income $ 4,250

  5. 11.4 Fairways Driving Range Example (concluded) • Estimated annual cash inflows: $5,000 + 4,000 - 750 = $8,250 • r= 15%, t=5. The base-case NPV is: NPV = -I + C x {1 - [1/(1 + r)t]}/r NPV = $-20,000 + ($8,250  {1 - [1/(1.15)5]}/.15) = $7,654.

  6. 11.5 Fairways Driving Range Scenario Analysis INPUTS FOR SCENARIO ANALYSIS Scenario analysis: putting lower and upper bounds on cash flows. Poor revenues with high costs, high revenues with low costs. • Base Case: Rentals are 20,000 buckets, variable costs are 10% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. • Best Case: Rentals are 25,000 buckets, variable costs are 8% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. • Worst Case: Rentals are 15,000 buckets, variable costs 12% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%.

  7. 11.5 Fairways Driving Range Best Case Scenario • Best Case: Rentals are 25,000 buckets, variable costs are 8% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. Revenues (25k x $3): $75,000 Variable Costs (.08 x 75k): 6,000 Fixed Costs: 45,000 Depreciation (20k /5yrs): 4,000 EBIT: 20,000 Taxes (@15%) 3,000 Net Income $ 17,000 OCF = EBIT + Dep. - Taxes = 20,000 + 4,000 - 3,000 = 21,000

  8. 11.5 Fairways Driving Range:Worst Case Scenario • Worst Case: Rentals are 15,000 buckets, variable costs 12% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. Revenues (15k x $3): $45,000 Variable Costs (.12 x 45k): 5,400 Fixed Costs: 45,000 Depreciation (20k /5yrs): 4,000 EBIT: -9,400 Taxes (@15%) 0 Net Income $ -9,400 OCF = EBIT + Dep. - Taxes = -9,400 + 4,000 - 0 = -5,400

  9. 11.5 Fairways Driving Range Scenario Analysis (concluded) Scenario Rentals(units) Revenues Net Income Cash Flow Best Case 25,000 $75,000 $17,000 $21,000 Base Case 20,000 60,000 4,250 8,250 Worst Case 15,000 45,000 -9,400 -5,400 Note that the worst case results in a tax credit. This assumes that the owners had other income against which the loss is offset.

  10. 11.6 Fairways Driving Range Sensitivity Analysis INPUTS FOR SENSITIVITY ANALYSIS Sensitivity analysis: hold all projections constant except one, alter that one, and see how sensitive cash flow is to that one when it changes - the point is to get a fix on where forecasting risk may be especially severe. • Base Case: Rentals are 20,000 buckets, variable costs are 10% of revenues, fixed costs are $45,000, 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 15,000 buckets and revenues are $45,000. All other variables are unchanged.

  11. 11.6 Fairways Driving Range : Best Case Sensitivity Analysis • Best Case: Rentals are 25,000 buckets, variable costs are 10% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. Revenues (25k x $3): $75,000 Variable Costs (.10 x 75k): 7,500 Fixed Costs: 45,000 Depreciation (20k /5yrs): 4,000 EBIT: 18,500 Taxes (@15%) 2,775 Net Income $ 15,725 OCF = EBIT + Dep. - Taxes = 18,500 + 4,000 - 2,775 = 19,725 NPV = $-20,000 + ($19,725  {1 - [1/(1.15)5]}/.15) = $46,121.

  12. 11.6 Fairways Driving Range :Worst Case Sensitivity Analysis • Worst Case: Rentals are 15,000 buckets, variable costs are 10% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. Revenues (15k x $3): $45,000 Variable Costs (.10 x 45k): 4,500 Fixed Costs: 45,000 Depreciation (20k /5yrs): 4,000 EBIT: -8,500 Taxes (@15%) 1,275 Net Income -$ 7,225 OCF = EBIT + Dep. - Taxes = -8,500 + 4,000 + 1,275 = -3,225 *Assume a tax credit is created in the worst case. NPV = $-20,000 + (-3,225  {1 - [1/(1.15)5]}/.15) = -$30,811.

  13. 11.6 Fairways Driving Range Sensitivity Analysis (concluded) Scenario Rentals Revenues Net Income Cash Flow NPV Best Case 25,000 $75,000 $15,725 $19,725 $46,121 Base Case 20,000 60,000 4,250 8,250 $7,655 Worst Case 15,000 45,000 -7,225 -3,225 -$30,811 Note that the worst case results in a tax credit. This assumes that the owners had other income against which the loss is offset.

  14. 11.7 Fairways Driving Range: Rentals vs. NPV Fairways Sensitivity Analysis - Rentals vs. NPV NPV Best case NPV = $46,121 $60,000 x Base case NPV = $7,655 x 0 Worst case NPV = -$30,811 x -$60,000 25,000 15,000 20,000 Rentals per Year

  15. 11.8 Fairways Driving Range: Total Cost Calculations • TC = VC + FC TC = (Q x v ) + FC Rentals Variable Cost Fixed Cost Total Cost 0 $0 $45,000 $45,000 15,000 4,500 45,000 49,500 20,000 6,000 45,000 51,000 25,000 7,500 45,000 52,500

  16. 11.9 Fairways Driving Range: Break-Even Analysis Fairways Break-Even Analysis - Sales vs. Costs and Rentals Sales and Costs Total Revenues $80,000 Break-Even Point 18,148 Buckets Net Income > 0 $50,000 Fixed Costs + Dep $49,000 Net Income < 0 $20,000 25,000 15,000 20,000 Rentals per Year

  17. 11.10 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) = ($45,000 + 4,000)/($3.00 - .30) = 18,148 buckets

  18. 11.11 Chapter 11 Example Assume you have the following information: • Price = $5 per unit; variable costs = $3 per unit • Fixed operating costs = $10,000 • Initial cost is $20,000 • 5 year life; straight-line depreciation to 0, no salvage value • Assume no taxes • Required return = 20%

  19. 11.11 Chapter 11 Example • Break-Even Computations A. Accounting Break-Even Q = (FC + D)/(P - v) = ($10,000 + $4,000)/($5 - 3) = 7,000 units. EBIT = 5 x 7,000 - 3 x 7,000 - 10,000 - 4,000) = 0 OCF = 0 + 4,000 - 0 = 4,000 r = 20% t = 5 years Initial cost = $20,000 IRR = 0 ; NPV = -$8,038

  20. 11.11 Chapter 11 Example • Break-Even Computations B. Cash Break-Even Q = FC/(P - v) = $10,000/($5 - 3) = 5,000 units. EBIT = 5 x 5,000 - 3 x 5,000 - 10,000 - 4,000) = -4,000 OCF = -4,000 + 4,000 - 0 = 0 r = 20% t = 5 years Initial cost = $20,000 IRR = -100% ; NPV = -$20,000

  21. 11.11 Chapter 11 Example • C. Financial Break-Even Q = (FC + OCF)/(P - v), where OCF is the level of OCF that results in a zero NPV. A project that breaks even on a financial basis has a discounted payback equal to its life, a zero NPV, and IRR just equal to the required return. NPV = -I + C x {1 - [1/(1 + r)t]}/r C x {1 - [1/(1 + r)t]}/r = NPV + I NPV = 0, r = 20%, t = 5 years, Initial cost = $20,000 C x {1 - [1/(1.205]}/.20 = 0 + 20,000 C x 2.9906 = 20,000 C = 20,000 / 2.9906 = 6,688 Q = (FC + OCF)/(P - v)=($10,000 + 6,688)/($5 - 3) = 8,344 units IRR = 20% ; NPV = 0, Payback=5 years.

  22. 11.12 Summary of Break-Even Measures (Table 11.1) I. The General Expression Q = (FC + OCF)/(P - v) where: FC = total fixed costs, P =Price per unit, v =variable cost per unit. II. The Accounting Break-Even Point Q = (FC + D)/(P - v) At the Accounting BEP, Net income = 0. III. The Cash Break-Even Point Q = FC/(P - v) At the Cash BEP, OCF = 0. IV. The Financial Break-Even Point Q = (FC + OCF*)/(P - v) At the Financial BEP, NPV = 0. (OCF* is the OCF at which NPV = 0.)

  23. 11.13 Fairways Driving Range: Degree of Leverage (DOL) • DOL is a “multiplier” which measures the effect of a change in quantity sold on OCF. • %  in OCF = DOL  %  in Q • DOL = 1 + FC/OCF • For Fairways, let Q = 20,000 buckets. Ignoring taxes, OCF = $9,000 and fixed costs = $45,000. Fairway’s DOL = 1 + FC/OCF = 1 + $45,000/$9,000 = 6.0. In other words, a 10% increase (decrease) in quantity sold will result in a (6 x 10%) = 60% increase (decrease) in OCF. • 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.

  24. 11.14 Managerial Options and Capital Budgeting • Managerial options and capital budgeting • What is ignored in a static DCF analysis? Management’s ability to modify the project as events occur. • Contingency planning 1. The option to expand 2. The option to abandon 3. The option to wait • Strategic options Possible future investments that may result from an investment under consideration. Generally, the exclusion of managerial options from the analysis causes us to underestimate the “true” NPV of a project.

  25. 11.15 Capital Rationing • Capital rationing • Definition: The situation in which the firm has more good projects than money. • Soft rationing - limits on capital investment funds set within the firm. • Hard rationing - limits on capital investment funds set outside of the firm (i.e., in the capital markets).

  26. 11.17 Solution to Problem 11.1 • BetaBlockers, Inc. (BBI) manufactures sunglasses. The variable material cost is $0.63 per unit and the variable labor cost is $2.02 per unit. a. What is the variable cost per unit? VC = variable material cost + variable labor cost = $0.63 + $2.02 = $2.65 b. Suppose BBI incurs fixed costs of $415,000 during a year when production is 250,000 units. What are total costs for the year? TC = total variable costs + fixed costs = ($2.65)(250,000) + $ 415,000 = $ 1,077,500

  27. 11.17 Solution to Problem 11.1 (concluded) c. If the selling price is $5.50 per unit, does BBI break even on a cash basis? If depreciation is $150,000, what is the accounting break-even point? Q cash= (FC ) / (P - v) = $415,000/($5.5 - $ 2.65) = 145,614 units Q account = (FC + Dep) / (P - v) = ($415,000 + $ 150,000)/($5.50 - $2.65) = 198,246 units

  28. 11.18 Solution to Problem 11.13 • A proposed project has fixed costs of $25,000 per year. OCF at 4,000 units is $60,000. 1. Ignoring taxes, what is the degree of operating leverage (DOL)? DOL = 1 + FC/OCF = 1 + ($25,000/$60,000) = 1.4167 2. If quantity sold rises from 7,000 to 7,300, what will the increase in OCF be? %  Q = (7,300 - 7,000)/7,000 = 4.29% %  OCF = DOL(%  Q) =1.4167 x 4.29% = 6.07% New OCF = ($60,000)(1.0607) = $63,642 3. What is the new DOL? DOL at 7,300 units = 1 + ($25,000/$63,642) = 1.3928

More Related