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Project Analysis and Evaluation

Project Analysis and Evaluation . Forecasting Risk: the possibility that errors in projected Cash flows will lead to incorrect decisions Scenario Analysis: the determination of what happens to NPV estimates when we ask 'what if' questions. Sensitivity Analysis.

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Project Analysis and Evaluation

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  1. Project Analysis and Evaluation • Forecasting Risk: the possibility that errors in projected Cash flows will lead to incorrect decisions • Scenario Analysis: the determination of what happens to NPV estimates when we ask 'what if' questions

  2. Sensitivity Analysis • Investigation of what happens to NPV when only one variable is changed is known as Sensitivity analysis. • Simulation Analysis • A combination of scenario and sensitivity analysis where different variables are tested is known as simulation analysis.

  3. Data to Elaborate Concept • Total Cost of the Project: $ 200000 • Life of the Project: 5-years • Depreciation method: SLM • Salvage Value: 0 • Required Rate of Return: 12 % • Tax Rate: 34 %

  4. Analysis • Base CaseLower BoundUpper Bound Sales 6000 5500 6500 Price/unit 80 75 85 Var:Cost 60 58 62 Fixed Cost 50000 45000 55000

  5. Income Statement Sales (6000 X 80 ) $ 480000 -V. Cost (60 X 6000) 360000 -Fixed Cost 50000 -Depreciation 40000 EBIT 30000 -Taxes (@ 34 %) 10200 • Net Income 19800

  6. Operating Cash Flows (OCF) • Net Income + Depreciation, or • 19800 + 40000 = 59800. At 12 % for 5 years the Annuity Factor comes to $ 3. 6048 • So the base case NPV = 59800 X 3.6048 minus 200000 (initial investment) = $ 15567

  7. Scenario Analysis Worst CaseBest Case Sales 5500 6500 Price 75 85 -VC 62 58 -FC 55000 45000

  8. Net Income of all the three possibilities Base CaseWorst CaseBest Case Sales 480000 412500 552500 -VC 360000 341000 377000 -FC 50000 55000 45000 -Dep 40000 40000 40000 EBIT 30000 -23500 90500 -Taxes 10200 +7990 30770 Net Income 19800 -15510 59730 OCF: 59800 (-15510 +Dep) =24490 (59730 + Dep)=99730

  9. Analysis NPV for base case is = 19800 X 3.6048 - 200000 = $ 15567 NPV for worst case is = 24490 X 3. 6048 - 200000 = $ -111719 NPV for best case is = 99730 X 3.6048 200000 = $ 159504

  10. Analysis: Continued… In worst scenario the Cash flow is still positive, i.e., 24490 It's good news but the bad news is the negative NPV of - 111719 And we stand to loose more than 50 % of our investment under the worst possible conditions.

  11. Analysis: Continued…. For the best case scenario the Cash flow is 59730 and the NPV is $ 159730 which offers an attractive 41 % return on our original investment of $ 200000 because if we calculate the IRR it comes to 40.9%.

  12. Sensitivity Analysis • Investigation of what happens to NPV when only one variable is changed. It is useful in highlighting the area where forecasting risk is especially severe.

  13. Now apply 'Base case variable' to 'Best' and 'Worst' (freeze variables of the best and worst case except sales) Best CaseWorst Case Sales ( 6500 X 80) 520000 (5500 X 80) 440000 VC (6500 X 60) 390000 (5500 X 60) 330000 FC 50000 50000 Dep. 40000 40000 EBIT 40000 20000 Taxes 13600 6800 Net Income 2640013200 OCF= 26400 + 40000 = 66400OCF 13200 + 40000 = 53200 NPV =66400 X 3.6048 - 200000 NPV = 53200X3.6048-200000= = 39358= -8224

  14. Now freeze everything except fixed cost and repeat the analysis Best Case Worst Case Sales ( 6000 X 80) 480000 480000 -VC (6000 X 60) 360000 360000 -FC 45000 55000 -Dep. 40000 40000 EBIT 35000 25000 -Taxes 11900 8500 Net Income 2310016500

  15. Operating Cash Flows & NPV Best OCF = 23100 + 40000 = 63100 Worst OCF = 16500 + 40000 = 56500 • NPV of Best caseNPV of worst case 63100 X 3.6048 – 56500X3.6048- 200000 = 27462 200000= 3671

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