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FINE 3010-01 Financial Management. Instructor: Rogério Mazali Lecture 11: 11/11/11. FINE 3010-01 Instructor: Rogério Mazali. Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus McGraw Hill/Irwin. Chapter 10: Project Analysis. Agenda.

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fine 3010 01 financial management

FINE 3010-01Financial Management

Instructor: RogérioMazali

Lecture 11: 11/11/11

fine 3010 01 instructor rog rio mazali
FINE 3010-01Instructor: RogérioMazali

Fundamentals of Corporate Finance

Sixth Edition

Richard A. Brealey

Stewart C. Myers

Alan J. Marcus

McGraw Hill/Irwin

Chapter 10:

Project Analysis

agenda
Agenda
  • How Firms Organize the Investment Process
    • Stage 1: The Capital Budget
    • Stage 2: Project Authorizations
  • Some “What If” Questions
    • Sensitivity Analysis
    • Scenario analysis
  • Break-Even Analysis
    • Accounting Break-even Analysis
    • NPV Break-even analysis
  • Real Options and the Value of Flexibility
    • Option to Expand
    • Option to abandon
    • The timing option
    • Flexible Production Facilities
how firms organize the investment process
How Firms Organize the Investment Process
  • Capital Budget: the list of all planned investment projects
  • The Decision Process
    • Develop and rank all investment projects = The Capital Budget
    • Authorize projects based on:
      • Outlays required by law or company policy
      • Maintenance or cost reduction
      • Capacity expansion in existing business
      • Investment for new products
how firms organize the investment process1
How Firms Organize the Investment Process
  • Capital Budgeting Problems
    • Ensuring that forecasts are consistent
      • Example: Optimistic division 1 manager vs. pessimistic division 2 manager
    • Eliminating conflicts of interest
      • Example: new plant managers selecting quick-payback projects to show performance right away
    • Reducing forecast bias
      • Example: Eurotunnel (costs were far higher than anticipated)
    • Sorting the wheat from the chaff - Selection criteria (NPV and others)
some what if questions
Some “What-If” Questions
  • Cash Flows are not certain: need to assess risk of project
  • Ways to handle uncertainty:
    • Sensitivity Analysis- Analysis of the effects on project profitability of changes in ONE variable: sales, costs, etc.
    • Scenario Analysis - Project analysis given a particular combination of assumptions, the “scenario”.
    • Simulation Analysis– computer simulation of a large number of scenarios.
    • Break Even Analysis- Analysis of the level of sales at which the company breaks even.
sensitivity analysis
Sensitivity Analysis
  • Objective: identify what are the variables the affect CF’s the most
  • Example: Opening store in Gravenstein. Given the expected cash flow forecasts listed on the next slide, determine the NPV of the project given changes in the cash flow components using an 8% cost of capital. Assume that all variables remain constant, except the one you are changing.
sensitivity analysis1
Sensitivity Analysis

Example – continued (,000s)

NPV= $478,141.00

sensitivity analysis3
Sensitivity Analysis
  • Limits to Sensitivity Analysis:
    • Ambiguous results: what exactly is pessimistic and optimistic?
    • Underlying variables might be interrelated: in this case, it makes no sense to change one variable and keep the others constant
scenario analysis
Scenario Analysis
  • Objective: see how firm cash flows would behave in particular situations (scenarios)
  • Example: you are worried Stop and Scoff may decide to open a store in nearby Salome. That would reduce sales in your Gravenstein store by 15%, and you might be forced into a price war to keep the remaining business. Prices might be reduced to the point that variable costs equal 82% of revenue.
  • See Excel.
break even analysis
Break-Even Analysis
  • Objective: answer how far mis-estimations can go before you start to lose money
  • In many cases, the “make-or-break” variable is sales => sales is the most used variable in break-even analysis
  • However, you might also look at other variables, like costs
break even analysis1
Break-Even Analysis

Example

Given the forecasted data on the next slide, determine the number of planes that the company must produce in order to break even, on an NPV basis. The company’s cost of capital is 10%.

break even analysis3
Break-Even Analysis

Answer 1: Accounting Break-Even Analysis

The break even point, is the # of Planes Sold that makes accounting profits = $0.00.

46 planes per year must be sold…or 280 planes over 6 years.

break even analysis4
Break-Even analysis

Answer 2: NPV Break-Even Analysis

The break even point, is the # of Planes Sold that generates a NPV=$0.

The present value annuity factor of a 6 year cash flow at 10% is 4.355

Thus,

break even analysis5
Break-Even Analysis

Answer

Solving for “Planes Sold”

operating leverage
Operating Leverage

Operating Leverage- The degree to which costs are fixed.

Degree of Operating Leverage (DOL) - Percentage change in profits given a 1 percent change in sales.

operating leverage3
Operating Leverage

Example - A company has sales outcomes that range from $16mil to $19 mil, depending on the economy. The same conditions can produce profits in the range from $550,000 to $1,112,000. What is the DOL?

real options and the value of flexibility
Real Options and the Value of Flexibility
  • Decision Trees - Diagram of sequential decisions and possible outcomes.
  • Decision trees help companies determine their Options by showing the various choices and outcomes.
  • The Option to avoid a loss or produce extra profit has value.
  • The ability to create an Option thus has value that can be bought or sold.
  • Types of Options:
  • Option to expand
  • Option to abandon
  • Timing option
  • Flexible production facilities
real options and the value of flexibility1
Real Options and the Value of Flexibility
  • Example: diet Whiskey
    • Market research: $200K
    • Chance of success: 50%
    • Cost of Capital: 12%
    • If success, build $2m plant that will generate perpetuity of $480K, and NPV = -$2m + $480K/.12 = $2m.
    • If not successful, plant generates $0, and NPV = $-2m.
    • Project can be carried out without the test, but firm will not know in advance whether the project will be successful.
real options and the value of flexibility3
Real Options and the value of Flexibility
  • Example: Wenkel Engines, Inc.
    • 2 technologies: A and B
    • Technology A uses custom-designed machines at low cost. If engine does not sell, equip. is worthless, and plant can be sold at $1m.
    • Technology B uses standard production lines, that can be sold at $4m if engines do not sell. Plant can be sold at $1m.
    • Two states of nature: high and low demand, w/ 50% probability each.
      • High demand: final decision is continue and make NPV = $20 m with tech. A and NPV = $18m with tech. B.
      • Low demand: abandon, and get salvage values.