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Project Analysis and Evaluation

Chapter Eleven. Project Analysis and Evaluation. Key Concepts and Skills. Understand forecasting risk and sources of value Understand and be able to do scenario and sensitivity analysis Understand the various forms of break-even analysis Understand operating leverage

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Project Analysis and Evaluation

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  1. Chapter Eleven Project Analysis and Evaluation

  2. Key Concepts and Skills • Understand forecasting risk and sources of value • Understand and be able to do scenario and sensitivity analysis • Understand the various forms of break-even analysis • Understand operating leverage • Understand managerial options and capital rationing

  3. Chapter Outline • Evaluating NPV Estimates • Scenario and Other What-If Analyses • Break-Even Analysis • Operating Cash Flow, Sales Volume, and Break-Even • Operating Leverage • Additional Considerations in Capital Budgeting

  4. Evaluating NPV Estimates 11.1 • NPV estimates are just that – estimates • A positive NPV is a good start – now we need to take a closer look • Estimated future cash flows – our estimate of future cash flow is an expected value. • Forecasting risk – how sensitive is NPV to changes in the cash flow estimates? • The more sensitive, the greater the forecasting risk • Need to understand the assumptions that underlie the cash flow forecasts

  5. Creating Positive NPV Projects • Sources of value – why does this project create value? • Is the new product better than the competition? • Can we manufacture it more cheaply? • Can we distribute it more effectively? • Can we spot an underserved market niche that we can control? • Example: Rubbermaid enters the trash bag business • Positive NPV projects are hard to find in highly competitive industries • Be aware of forecasts that extrapolate from historical trends • Example: New York 1850: spit & horse manure – 1 cm 1860: spit & horse manure – 2.5 cm 1870: (estimate – 5 cm) 1880: (estimate – 10 cm) 1960: (estimate – 22.5 meters)

  6. Scenario Analysis 11.2 • What happens to NPV under different cash flows scenarios? • At the very least look at: • Base case – based on forecasted future cash flows • Best case – revenues are high and costs are low • Worst case – revenues are low and costs are high • Measures the range of possible outcomes • While best case and worst case are not necessarily probable, they can still be possible

  7. New Project Example • Consider the project discussed in the text • The initial cost is $200,000 and the project has a 5-year life. There is no salvage value. Depreciation is straight-line, the required return is 12% and the tax rate is 34% • Upper & lower bounds are within 10% of the base case

  8. New Project Example • Calculate Net Income for the base case • Calculate cash flow for the base case:

  9. New Project Example • Calculate the NPV for the base case • Now want to recalculate the NPV using a variety of different scenarios. Establish the best & worst cases by using the upper & lower bounds for each variable.

  10. Summary of Scenario Analysis What conclusions can we draw from this? Should we undertake the project?

  11. Sensitivity Analysis • What happens to NPV when we vary one variable at a time • This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV • The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable and the more attention we want to pay to its estimation • In the first table on the next page, we calculate cash flow, NPV and IRR assuming all variables are fixed at the level of the base case, other than sales volume. • Sales volume is allowed to vary between the best (6,500 units) & worst (5,500 units) cases • In the second table, we assume all variables are fixed other than fixed costs.

  12. Summary of Sensitivity Analysis for New Project Sensitivity to Unit Sales Sensitivity to Fixed Costs

  13. NPV Profile: Sensitivity Analysis – Unit Sales

  14. Simulation Analysis • Simulations are an expanded form of sensitivity and scenario analysis, wherein large numbers of possible outcomes are generated • Monte Carlo simulation can estimate thousands of possible outcomes based on conditional probability distributions and constraints for each of the variables • The output is a probability distribution for NPV with an estimate of the probability of obtaining a positive net present value • The simulation only works as well as the information that is entered and very bad decisions can be made if care is not taken to analyze the interaction between variables

  15. Making A Decision • Beware of “Paralysis from Analysis” • At some point you have to make a decision • If the majority of your scenarios have positive NPVs, then you can feel reasonably comfortable about accepting the project • If you have a crucial variable that leads to a negative NPV with a small change in the estimates, then you may want to forego the project

  16. Break-Even Analysis 11.3 & 11.4 • Based on our previous work, we have seen that sales volume is often closely tied to project profitability • Break-even analysis allows us to determine the level of sales at which the firm will just “break-even” • There are three common break-even measures • Accounting break-even – sales volume where net income = 0 • Cash break-even – sales volume where operating cash flow = 0 • Financial break-even – sales volume where net present value = 0

  17. Example: Costs • There are two types of costs that are important in breakeven analysis: fixed and variable • Variable costs – rise and fall with production. VC = cost per unit × quantity of units • Fixed costs - are constant, regardless of output, over some time period • Total costs = fixed + variable • Example: • Assume your firm has fixed costs of $8,000 per year and variable costs of $3.00 per unit. • What is your total cost if you produce 1,000 units? • What if you produce 5,000 units?

  18. Fixed & Variable Costs

  19. The Total Cost Curve

  20. Average vs. Marginal Cost • Average Cost • Total Cost / Number of units produced • Will decrease as number of units increases • Marginal Cost • The cost to produce one more unit • Same as variable cost per unit • Example: What is the average cost and marginal cost under each situation in the previous example • Produce 1,000 units: • Average = 11,000 / 1000 = $11 • Marginal = $3.00 • Produce 5,000 units: • Average = 23,000 / 5000 = $4.60 • Marginal = $3.00

  21. Accounting Break-Even • The quantity of output where net income is equal to zero • Lets begin with a simple example. We are going to sell CDs for $5 each. We can purchase the CDs wholesale at a price of $3. We have fixed costs of $600 and $300 in depreciation expenses. How many CDs do we need to sell to break-even? • The contribution margin is the difference between the sales price and the variable costs. Each unit sold contributes this amount towards the fixed costs. Depreciation is included with fixed cost since we are calculating an accounting break-even

  22. Accounting Break-Even • To see why accounting break-even is equal to fixed costs plus depreciation divided by the contribution margin: Where: Q – quantity of units P – price per unit sold v – variable cost per unit FC – fixed cost D - depreciation

  23. Using Accounting Break-Even • Accounting break-even is often used as an early stage screening number • If a project cannot break-even on an accounting basis, then it is not going to be a worthwhile project • Accounting break-even gives managers an indication of how a project will impact accounting profit

  24. Accounting Break-Even and Cash Flow • We are more interested in cash flow than we are in accounting numbers • As long as a firm has non-cash deductions, there will be a positive cash flow • If a firm just breaks-even on an accounting basis, cash flow = depreciation • If a firm just breaks-even on an accounting basis, NPV < 0

  25. Breakeven Example • Consider the following project • A new product requires an initial investment of $5 million and will be depreciated straight line to an expected salvage of zero over 5 years • The price of the new product is expected to be $25,000 and the variable cost per unit is $15,000 • The fixed cost is $1 million • What is the accounting break-even point each year? • Depreciation = 5,000,000 / 5 = 1,000,000 per year

  26. Breakeven Example continued • What is the operating cash flow at the accounting break-even point (ignoring taxes)? • What is the cash break-even quantity?

  27. Breakeven Example continued • What is the financial breakeven quantity? • Assume a required return of 18% • Accounting break-even = 200 units • Cash break-even = 100 units • What is the financial break-even point? • Similar process to finding the bid price 5,000,000 PV 0 FV 5 N 18 I PMT 1,598,889

  28. Three Types of Break-Even Analysis • Accounting Break-even • Where NI = 0 • Q = (FC + D)/(P – v) • Cash Break-even • Where OCF = 0 • Q = (FC + OCF)/(P – v) (ignoring taxes) • Financial Break-even • Where NPV = 0 • Cash BE < Accounting BE < Financial BE

  29. Operating Leverage 11.5 • Operating leverage is the relationship between sales and operating cash flow • Degree of operating leverage measures the sensitivity of operating cash flow to a change in sales • The higher the DOL, the greater the variability in operating cash flow for a 1% change in sales • The higher the fixed costs, the higher the DOL • DOL depends on the sales level you are starting from • DOL = 1 + (FC / OCF)

  30. Example: DOL • Consider the previous example • Suppose sales are 300 units • This meets all three break-even measures • What is the DOL at this sales level? • OCF = (25,000 – 15,000)*300 – 1,000,000 = 2,000,000 • DOL = 1 + (1,000,000 / 2,000,000) = 1.5 • What will happen to OCF if unit sales increases by 20%? • Percentage change in OCF = DOL*Percentage change in Q • Percentage change in OCF = 1.5(.2) = .3 or 30% • OCF would increase to 2,000,000(1.3) = 2,600,000

  31. Additional Considerations 11.6 • Managerial options and contingency planning • Option to expand • Option to abandon • Option to wait

  32. Capital Rationing • Capital rationing occurs when a firm or division has limited resources • Soft rationing – the limited resources are temporary, often self-imposed • Hard rationing – capital will never be available for this project • The profitability index is a useful tool when faced with soft rationing

  33. Quick Quiz • What is sensitivity analysis, scenario analysis and simulation? • Why are these analyses important and how should they be used? • What are the three types of break-even and how should each be used? • What is degree of operating leverage? • What is the difference between hard rationing and soft rationing?

  34. Summary 11.7 • You should know: • Forecasting risk results from estimates made in the NPV analysis • Scenario, sensitivity and simulation analysis are useful tools for dealing with forecasting risk • Breakeven analysis helps to identify critical levels of sales • Operating leverage reflects the degree to which operating cash flows are sensitive to changes in sales volume • Projects usually have future managerial options • Capital rationing happens when profitable projects cannot be accepted

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