Project Analysis Corporate Finance

8/13/2019 Project Analysis Corporate Finance

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Project Analysis

Session 5


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Investment Process

STAGE 1: THE CAPITAL BUDGET

STAGE 2: PROJECT AUTHORIZATIONS

PROBLEMS AND SOME SOLUTIONS

Ensuring that Forecasts Are Consistent

Eliminating Conflicts of Interest

Reducing Forecast Bias

Sorting the Wheat from the Chaff


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Some What If Questions

Managers want to understand more than the NPV of a project.

If NPV is positive, they must seek to understand why suchan attractive project did not come from a competitor.

And if the firm goes ahead with the project, and other copy asuch a profitable idea, will the firm still have some

competitive advantage? They also want to predict what events could happen in an

uncertain environment they operate and how that might affectNPV.

Once they have done these predictions, management candecide if it is worthwhile investing more time and effort inunderstanding the uncertainty and trying to resolve it.


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Introduction There are four methods managers use to

handle project uncertainty:

Sensitivity Analysis Scenario Analysis

Simulation Analysis

Break-Even Analysis


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Sensitivity Analysis

A sensitivity analysis calculates the consequencesof incorrectly estimating a variable in your NPVanalysis.

If forces you:

To identify the variables underlying your analysis.

To focus on how changes to these variablescould impact the expected NPV.

To consider what additional information shouldbe collected to resolve uncertainties about thevariables.


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Some What If

Questions

Finefodder is

considering openinga new superstore.

Cost of Capital 8%

NPV = 478,000

PV = $780,000 12-year annuity factor= $780,000 7.536 = $5.878 million

NPV = PVinvestment= $5.878 million$5.4 million = $478,000


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Simulation Analysis A scenario analysis is helpful to see how interrelated

variables impact NPV. But one must run severalhundred possible scenarios.

A simulation analysis uses a computer to generatehundreds, or even thousands, of possible scenarios.

A probability distribution is assigned to eachcombination of variables to create an entire range ofpotential outcomes.


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Sensitivity Analysis v/s Scenario Analysis

Sensitivity Analysis v/s Scenario Analysis Both calculate how NPV depends on input assumptions

Sensitivity analysis changes inputs one at a time

Scenario analysis changes several variables at once


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Break-Even Analysis

Accounting vs NPV Break-Even Analysis A Break-Even analysis shows the level of sales at

which a company breaks even.

An accounting break-even occurs where totalrevenues equal total costs (profits equal zero).

A NPV break-even occurs when the NPV of theproject equals zero.

Using accounting break-even can lead to poordecisions.

You can avoid this risk by using NPV break-evenin your analysis!


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Break-Even Analysis

Accounting Break-Even You estimated salesto be $16 million.

Variable costswere 81.25% of sales ($0.8125of variable costs per $1 of sales).

Fixed costswere $2 million and depreciationwas $450,000.

Break-Even Revenues = Fixed Costs + Depreciation

Profit per $1 of Sales

= $2,000,000 + $450,000 = $2,450,000 = $13,066,667$1 - $0.8125 $0.1875


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Break-Even Analysis

Accounting Break-Even Creating an income statement at $13,066,667 of

sales shows profit equals zero:

Revenues $13,066,667Variable Costs (81.25% of sales)10,616,667Fixed Costs + Depreciation 2,450,000Pretax Profit 0Taxes 0

Profit after Tax 0


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Break-Even Analysis

Accounting Break-Even If a project breaks even in accounting terms

is it an acceptable investment?

Clue: This project has a 12 year life

Would you be happy with an investment

which after 12 years gave you a zerototal rate of return?


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Break-Even Analysis

Accounting Break-Even A project which simply breaks even on an accounting

basis will always have a negative NPV!

Proof:

The initial investment is $5.4m. In each of the next 12 years, firm

receives a cashflow of $450,000. So firm gets its money back

Total operating cashflow= initial investment = 12*$450,000=$5.4m

But revenues are not suf f ic ient to repay the opportun i ty

cost o f that $5.4 mil l ion investm ent. NPV is negative.

Operating Cashflow = profit after tax + depreciation= $0 + $450,000 = $450,000


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Break-Even Analysis

Note: Cash flow = Depreciation + After Tax Profit


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Break-Even Analysis

NPV Break-EvenThis cash flow will last for 12 years. So to find its present value we multiplyby the 12-year annuity factor. With a discount rate of 8 percent, the presentvalue of $1 a year for each of 12 years is $7.536. Thus the present value ofthe cash flows is

PV (cash flows) = 7.536 (.1125 sales$1.02 million)

PV (cash flows) = investment7.536 (.1125 sales$1.02 million) = $5.4 million

$7.69 million + .8478 sales = $5.4 million

Sales = 5.4 + 7.69 / .8478

Sales = 15.4 million


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Break-Even Analysis

NPV Break-Even Using the accounting break-even, the

project had to generate sales of $13.067million to have zero profit.

Using the NPV break-even, we find that theproject needs sales of $15.4 million to havea zero NPV. The project needs to be 18% more successful to break-even on

a NPV basis!


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Flexibility in Capital Budgeting

The Value of Having Options No matter how much analysis you do on a project, it isimpossible to completely eliminate uncertainty.

A firm must have the option: To mitigate the effect of unpleasant surprises and

to take advantage of pleasant ones? Because the future is uncertain, successful financial managers

seek to build flexibility into a project.

The perfect project would have:

The option to expand if things go well.

The option to bail out or switch production if things go poorly.

The option to postpone if future conditions might improve.


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The Value of Having Options

As a general rule, flexibility will be most valuableto you when the future is most uncertain.

The ability to change course as events developand new information becomes available is mostvaluable when it is hard to predict withconfidence what the best course of action will be.

Good outcomes can be exploited, while pooroutcomes can be avoided or postponed.


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Decision treesare used to diagram theoptions in a project.

You can then determine the optimal courseof action from a series of potential options.

A decision tree is defined as a diagram ofsequential decisions and their possibleoutcomes.


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Example of Decision Tree

Donotstudy

Studyfinance

Squares represent decisions to be made.

Circles representreceipt of

information e.g. atest score.

The lines leading away

from the squaresrepresent thealternatives.

C

A

B

F

D

Project Analysis Corporate Finance

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