Chptr 4 Project Analysis And Evaluation 2vn6e

Chapter 4 Project Analysis and Evaluation

McGraw­Hill/Irwin

Copyright © 2010 by The McGraw­Hill Companies, Inc. All rights reserved.

Evaluating NPV Estimates • NPV estimates are just that – estimates • A positive NPV is a good start – now we need to take a closer look – Forecasting risk – how sensitive is our NPV to changes in the cash flow estimates; the more sensitive, the greater the forecasting risk – Sources of value – why does this project create value?

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Scenario Analysis • What happens to the NPV under different cash flow scenarios? • At the very least, look at: – Best case – high revenues, low costs – Worst case – low revenues, high costs – Measure of the range of possible outcomes

• Best case and worst case are not necessarily probable, but they can still be possible 11-3

• You are considering a new product launch. The project will cost RM1,700,000, have four year life, and have no salvage value; depreciation is straight line to zero. Sales are projected at 190 units per year; price per unit will be RM18,000, variable cost per unit will be RM11,200, and fixed costs will be RM410,000 per year. The required return on the project is 12 percent, and the tax rate is 35 percent.

•

Company thinks the unit sales, variable cost, and fixed cost are projections given are probably accurate to within ±10 percent. Calculate the Net Present Value (NPV) for base case, best case and worst case.

Scenario

Unit sales

Variable cost (RM)

Fixed costs (RM)

Base

190

11,200

410,000

Best

209

10,080

369,000

Worst

171

12,320

451,000

OCFbase = [(18,000 – 11,200)(190) – 410,000](0.65) + 0.35(1,700,000/4) OCFbase = $722,050 NPVbase = –1,700,000 + 722,050 x 1- (1/ (1 + 0.12)4 ) 0.12 NPVbase = 493,118.10

• Calculate for the 2 scenarios

• Evaluate the sensitivity of base case Net Present Value (NPV) to changes in fixed costs. •

To calculate the sensitivity of the NPV to changes in fixed costs we choose another level of fixed costs. We will use fixed costs of RM420,000. The OCF using this level of fixed costs and the other base case values with the tax shield approach, we get: OCF = [(18,000 – 11,200)(190)–420,000](0.65) + 0.35(1,700,000/4) OCF = 715,550 NPV = –1,700,000 + 715,550 x 1- (1/ (1 + 0.12)4 ) 0.12 NPV = 473,375.32

• The sensitivity of NPV to changes in fixed costs is: NPV/FC = (493,118.10 – 473,375.32)/(410,000 – 420,000) NPV/FC = –1.974 For every value increase in fixed costs, net present value falls by RM1.974

Sensitivity Analysis • What happens to NPV when we change 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

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Summary of Sensitivity Analysis for New Project Scenario

Unit Sales

Cash Flow

NPV

IRR

Base case

6,000

59,800

15,567

15.1%

Worst case

5,500

53,200

-8,226

10.3%

Best case

6,500

66,400

39,357

19.7%

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Simulation Analysis • Simulation is really just an expanded sensitivity and scenario analysis • 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 11-11

Making a Decision • Beware “Paralysis of 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

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Break-Even Analysis • Common tool for analyzing the relationship between sales volume and profitability • There are three common break-even measures – ing break-even – sales volume at which NI = 0 – Cash break-even – sales volume at which OCF =0 – Financial break-even – sales volume at which NPV = 0 11-13

Example: Costs • There are two types of costs that are important in breakeven analysis: variable and fixed Total variable costs = quantity * cost per unit –Fixed costs are constant, regardless of output, over some time period Total costs = fixed + variable = FC + vQ

• Example: –Your firm pays $3,000 per month in fixed costs. You also pay $15 per unit to produce your product. • What is your total cost if you produce 1,000 units? • What if you produce 5,000 units?

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Average vs. Marginal Cost • Average Cost TC / # of units –Will decrease as # 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 = 18,000 / 1000 = $18 –Produce 5,000 units: Average = 78,000 / 5000 = $15.60

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ing Break-Even • The quantity that leads to a zero net income • NI = (Sales – VC – FC – D)(1 – T) = 0 • QP – vQ – FC – D = 0 • Q(P – v) = FC + D • Q = (FC + D) / (P – v)

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Using ing BreakEven • ing break-even is often used as an early stage screening number • If a project cannot break-even on an ing basis, then it is not going to be a worthwhile project • ing break-even gives managers an indication of how a project will impact ing profit 11-17

ing Break-Even and Cash Flow • We are more interested in cash flow than we are in ing 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 ing basis, cash flow = depreciation • If a firm just breaks even on an ing basis, NPV will generally be < 0

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Example • Consider the following project – A new product requires an initial investment of $5 million and will be depreciated 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 ing break-even point each year? • Depreciation = 5,000,000 / 5 = 1,000,000 • Q = (1,000,000 + 1,000,000)/(25,000 – 15,000) = 200 units 11-19

Sales Volume and Operating Cash Flow • What is the operating cash flow at the ing break-even point (ignoring taxes)? OCF

OCF = (S – VC – FC - D) + D OCF = S – VC – FC = (200*25,000 – 200*15,000 – 1,000,000 1,000,000) + 1,000,000 = 1,000,000

• What is the cash break-even quantity? Q = FC / (P – v) Q = (0 + 1,000,000) / (25,000 – 15,000) = 100 units

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Three Types of Break-Even Analysis • ing Break-even Q = (FC + D) / (P – v) • Cash Break-even Q = FC / (P – v) • Financial Break-even Q = (FC + OCF) / (P – v) • Cash BE < ing BE < Financial BE

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Example: Break-Even Analysis • Consider the previous example – – – –

Assume a required return of 18% ing break-even = 200 Cash break-even = 100 What is the financial break-even point? • Similar process to that of finding the bid price • What OCF (or payment) makes NPV = 0? – N = 5; PV = 5,000,000; I/Y = 18; T PMT = 1,598,889 = OCF

• Q = (1,000,000 + 1,598,889) / (25,000 – 15,000) = 260 units

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Operating Leverage • Operating leverage is the relationship between sales and operating cash flow • Degree of operating leverage measures this relationship – The higher the DOL, the greater the variability in operating cash flow – The higher the fixed costs, the higher the DOL – DOL depends on the sales level you are starting from DOL = 1 + (FC / OCF)

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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 11-24

Capital Rationing • Capital rationing occurs when a firm or division has limited resources – Soft rationing – the situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting. – Hard rationing – the situation that occurs when a business cannot raise financing for a project under any circumstances. • The profitability index is a useful tool when a manager is faced with soft rationing

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Comprehensive Problem • A project requires an initial investment of $1,000,000 and is depreciated straight-line to zero salvage over its 10-year life. The project produces items that sell for $1,000 each, with variable costs of $700 per unit. Fixed costs are $350,000 per year. • What is the ing break-even quantity, operating cash flow at ing break-even, and DOL at that output level?

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Solution ing break-even: •Q = (FC + D) / (P – V) = ($350,000 + $100,000) / ($1,000 - $700) = 1,500 units •OCF = ( S – VC – FC – D) + D = ([1,500 x $1,000] – [1,500 x $700] - $350,000 - $100,000) + $100,000 = $100,000 •DOL = 1 + (FC / OCF) = 1 + ($350,000 / 100,000) = 4.5

CLASS EXERCISE • Olin Transmissions, Inc., has the following estimates for its new gear assembly project: price RM1,900 per unit: variable costs = RM240 per unit; fixed costs = RM 4.8 million; quantity = 95,000 units. Suppose the company believes all of its estimates are accurate only within ± 15%. What values should the company use for the four variables given here when it performs its best case scenario analysis? What about the worst case scenario?

• A project has the following data: Price = $57 per unit Variable cost = $32 per unit Fixed cost = $9,000 Required return = 12% Initial Investment = $18,000 Life= 4 years Depreciation = straight line method Calculate:

• ing break even • Cash break even • Financial break even

Boh Valley is a company produces tea. The company recently change its packing machine. The machine's initial cost is RM2,000, and the depreciation value is RM250 per year. The machines have 4 years project life. The fixed costs of the machine RM2,000 per year and variable cost is RM6 per unit. A packet of tea is selling at RM20. Boh Valley required rate of return is 10 percent. Calculate: •ing break even. •Financial break-even point for the project. •Cash break even

Tutorial • Ross, Westerfield, Jordon (2010). Fundamental of Corporate Finance, 9 th Edition

• Q: 1, 5, 9, 13, 19 • Pages: 360 - 362