Project Analysis and Project Analysis and EvaluationEvaluation   Forecasting Risk: the Forecasting Risk: the

possibility that errors in possibility that errors in projected Cash flows will lead projected Cash flows will lead to incorrect decisionsto incorrect decisions

Scenario Analysis: the Scenario Analysis: the determination of what happens to determination of what happens to NPV estimates when we ask 'what NPV estimates when we ask 'what if' questionsif' questions

Sensitivity AnalysisSensitivity Analysis

Investigation of what happens to NPV Investigation of what happens to NPV when only one variable is changed is when only one variable is changed is known as Sensitivity analysis.known as Sensitivity analysis.

   Simulation AnalysisSimulation Analysis    A combination of scenario and A combination of scenario and

sensitivity analysis where different sensitivity analysis where different variables are tested is known as variables are tested is known as simulation analysis.simulation analysis.

Data to Elaborate Data to Elaborate ConceptConcept Total Cost of the Project:Total Cost of the Project: $ $

200000200000 Life of the Project:Life of the Project: 5-years5-years Depreciation method:Depreciation method: SLMSLM Salvage Value:Salvage Value: 00 Required Rate of Return:Required Rate of Return: 12 %12 % Tax Rate:Tax Rate: 34 %34 %

AnalysisAnalysis

   Base CaseBase Case Lower BoundLower Bound Upper BoundUpper Bound

SalesSales 6000 6000 55005500 6500 6500

Price/unit 80Price/unit 80 75 75 85 85

Var:Cost 60 58Var:Cost 60 58 62 62

Fixed Cost 50000Fixed Cost 50000 45000 45000 55000 55000

Income StatementIncome Statement

Sales (6000 X 80 )Sales (6000 X 80 ) $ 480000$ 480000

-V. Cost (60 X 6000)-V. Cost (60 X 6000) 360000 360000

-Fixed Cost-Fixed Cost 50000 50000

-Depreciation-Depreciation 40000 40000

EBITEBIT 30000 30000

-Taxes (@ 34 %)-Taxes (@ 34 %) 10200 10200 Net IncomeNet Income 19800 19800

Operating Cash Flows Operating Cash Flows (OCF)(OCF) Net Income + Depreciation, or Net Income + Depreciation, or 19800 + 40000 = 59800. At 12 % 19800 + 40000 = 59800. At 12 %

for 5 years the Annuity Factor for 5 years the Annuity Factor comes to $ 3. 6048comes to $ 3. 6048

So the base case NPV = 59800 X So the base case NPV = 59800 X 3.6048 minus 200000 (initial 3.6048 minus 200000 (initial investment) = $ 15567investment) = $ 15567

Scenario AnalysisScenario Analysis

Worst CaseWorst Case Best Best CaseCase

SalesSales 5500 5500 6500 6500

PricePrice 75 75 85 85

-VC-VC 62 62 58 58

-FC-FC 55000 55000 45000 45000

  

Net Income of all the three Net Income of all the three possibilitiespossibilities

Base CaseBase Case Worst CaseWorst CaseBest CaseBest Case

SalesSales 480000480000 412500412500 552500552500

-VC-VC 360000360000 341000341000 377000377000

-FC-FC 50000 50000 55000 55000 45000 45000

-Dep -Dep 40000 40000 40000 40000 40000 40000

EBITEBIT 3000030000 -23500 -23500 90500 90500

-Taxes-Taxes 10200 10200 +7990 +7990 30770 30770

Net Income Net Income 19800 19800 -15510 -15510 59730 59730

OCF: 59800 (-15510 +Dep) =24490 (59730 + OCF: 59800 (-15510 +Dep) =24490 (59730 + Dep)=99730Dep)=99730

AnalysisAnalysis

NPV for base case is = 19800 X 3.6048 - NPV for base case is = 19800 X 3.6048 - 200000 = $ 15567200000 = $ 15567

NPV for worst case is = 24490 X 3. 6048 - NPV for worst case is = 24490 X 3. 6048 - 200000 = $ -111719 200000 = $ -111719

NPV for best case is = 99730 X 3.6048NPV for best case is = 99730 X 3.6048

200000 = $ 159504200000 = $ 159504

Analysis: Continued…Analysis: Continued…

In worst scenario the Cash flow is stillIn worst scenario the Cash flow is still

positive, i.e., 24490positive, i.e., 24490

It's good news but the bad news is theIt's good news but the bad news is the

negative NPV of - 111719negative NPV of - 111719

And we stand to loose more than 50 % ofAnd we stand to loose more than 50 % of

our investment under the worst possibleour investment under the worst possible

conditions.conditions.   

Analysis: Continued….Analysis: Continued….

For the best case scenario the Cash flow isFor the best case scenario the Cash flow is

59730 and the NPV is $ 159730 which59730 and the NPV is $ 159730 which

offers an attractive 41 % return on ouroffers an attractive 41 % return on our

original investment of $ 200000 because iforiginal investment of $ 200000 because if

we calculate the IRR it comes to 40.9%.we calculate the IRR it comes to 40.9%.

  

Sensitivity AnalysisSensitivity Analysis

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

Now apply 'Base case variable' to 'Best' Now apply 'Base case variable' to 'Best' and 'Worst' (freeze variables of the best and 'Worst' (freeze variables of the best and worst case except sales)and worst case except sales)

Best CaseBest Case Worst CaseWorst Case

Sales ( 6500 X 80)Sales ( 6500 X 80) 520000 520000 (5500 X 80) (5500 X 80) 440000 440000

VC (6500 X 60)VC (6500 X 60) 390000 390000 (5500 X 60)(5500 X 60) 330000 330000

FCFC 50000 50000 50000 50000

Dep.Dep. 4000040000 40000 40000

EBITEBIT 40000 40000 20000 20000

TaxesTaxes 1360013600 6800 6800

Net IncomeNet Income 2640026400 1320013200

  

OCFOCF= 26400 + 40000 = = 26400 + 40000 = 6640066400 OCF OCF 13200 + 40000 = 13200 + 40000 = 5320053200

  

NPV =66400 X 3.6048 - 200000 NPV = 53200X3.6048-200000=NPV =66400 X 3.6048 - 200000 NPV = 53200X3.6048-200000=

= = 3935839358 = -8224= -8224

Now freeze everything except fixed Now freeze everything except fixed cost and repeat the analysiscost and repeat the analysis

Best CaseBest Case Worst CaseWorst Case

Sales ( 6000 X 80)Sales ( 6000 X 80) 480000480000 480000 480000

-VC (6000 X 60)-VC (6000 X 60) 360000360000 360000 360000

-FC-FC 45000 45000 55000 55000

-Dep.-Dep. 4000040000 40000 40000

EBITEBIT 35000 35000 25000 25000

-Taxes-Taxes 1190011900 8500 8500

Net IncomeNet Income 2310023100 1650016500

  

Operating Cash Flows & Operating Cash Flows & NPVNPV

Best OCF Best OCF = 23100 + 40000 = = 23100 + 40000 = 6310063100

Worst OCF =Worst OCF = 16500 + 40000 = 16500 + 40000 = 5650056500

   NPV of Best caseNPV of Best case NPV of worst caseNPV of worst case

63100 X 3.6048 – 56500X3.6048-63100 X 3.6048 – 56500X3.6048-

200000 = 200000 = 2746227462 200000= 200000= 36713671