1. Chapter 10 Learning Objectives
1. Appreciate the practical problems of capital budgeting in large corporations.
2. Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts.
3. Understand why an overestimate of sales is more serious for projects with high operating leverage.
4. Recognize the importance of managerial flexibility in capital budgeting.

2. Project Analysis
Chapters 8 and 9 develop a framework for project analysis.
This chapter analyzes the robustness of a project’s value by asking some “What If” Questions.
Chapter 10 Outline
How Firms Organize the Investment Process
Some “What If” Questions
Sensitivity Analysis
Scenario Analysis
Break Even Analysis
Real Options and the Value of Flexibility 2

3. Capital Budget Capital Budget – A list of planned investment projects.
Capital Budget - The list of planned investment projects. 4

4. Capital Budgeting: The Decision Process
Stage 1: The Capital Budget
Stage 2: Project Authorization
Outlays required by law or company policy
Maintenance or cost reduction
Capacity expansion in existing business
Investment for new products
Capital Budget - The list of planned investment projects. 4

5. Potential Capital Budgeting Problems
Ensuring forecasts are consistent
Eliminating conflicts of interest
Reducing forecast bias
Proper selection criteria (NPV and others) 5

6. What-if Testing
Sensitivity Analysis - Analysis of the effects on project profitability of changes in sales, costs, etc.
Scenario Analysis – Analysis given a particular combination of assumptions.
Simulation Analysis - Estimation of the probabilities of different possible outcomes.
Break-Even Analysis - Analysis of the level of sales at which the company breaks even.
Sensitivity Analysis - Analysis of the effects on project profitability of changes in sales, costs, etc.
Scenario Analysis - Project analysis given a particular combination of assumptions.
Simulation Analysis - Estimation of the probabilities of different possible outcomes.
Break-Even Analysis - Analysis of the level of sales at which the company breaks even. 6

7. Why is sensitivity analysis useful?
Analysis of the effects on project profitability of changes in sales, costs, etc.
Why is sensitivity analysis useful?
Sensitivity Analysis - Analysis of the effects on project profitability of changes in sales, costs, etc. 6

8. Sensitivity Analysis - Example
Base Case: Expected cash flows from a new project (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s)
Calculate:
NPV = $1,382.47
IRR = 12.7%
Payback Period = 6 years
Profitability Index = .256
NPV =
IRR =
Payback Period =
Profitability Index = 8

9. Sensitivity Analysis - Example
Possible Range of Variables 9

10. Sensitivity Analysis: Changing Sales (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s)
Pessimistic Case—Sales = $14, Optimistic Case—Sales = $18,000
Note: It is recommended for practice that students calculate the other valuation techniques learned in Chapter 8 (IRR, etc)
NPV = -$426
NPV = $3,191 8

11. Sensitivity Analysis: Changing Fixed Costs (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s)
Pessimistic Case—Fixed Costs = $2,500 Optimistic Case—Fixed Costs = $1,500
Note: It is recommended for practice that students calculate the other valuation techniques learned in Chapter 8 (IRR, etc)
NPV = -$878
NPV = $3,643 8

12. Limits to Sensitivity Analysis
Ambiguous
How do you consistently define “optimistic” or “pessimistic”?
Interrelatedness of variables 6

13. Scenario Analysis
Scenario Analysis – Project analysis given a particular combination of assumptions.
Why is it useful?
Simulation Analysis – Estimation of the probabilities of different possible outcomes, e.g., from an investment project.
Scenario Analysis - Project analysis given a particular combination of assumptions.
Simulation Analysis –Estimation of the probabilities of different possible outcomes, e.g., from an investment project.
Why is it useful? 6

14. Scenario Analysis: Introducing Competition
Assume that it will take two years for competition to enter the market. At this time, sales drop 10% and variable costs increase to 82% (increased labor demand). What happens to NPV under this scenario?
Base Case – No Competition Scenario – Introduce Competition
14,400
NPV = $1,382
NPV = -$717 8

15. Break-Even Analysis
Break-Even Analysis - Analysis of the level of sales at which the project breaks even.
Why is this useful?
Break-even Analysis – Analysis of the level of sales at which the project breaks even. 12

16. Break-Even Analysis – Example (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s)
Determine the number of units that must be sold in order to break even, on an NPV basis.
Suppose each unit has a price point of $45,000
All other variables are at their base case levels 13

17. Break-Even Point: Accounting
Break-Even Point (Accounting) - The break-even point is the number of units sold where net profits = $0.
What does the accounting break-even point not account for? 14

18. Break-Even Point: Finance
NPV Break-Even Point (Finance):
How can we find the present value of future cash flows? As long as cash flows are equal each year, we can use the Annuity Factor.
NPV break-even point – Level of sales at which project net present value becomes positive. 14

19. Break-Even Analysis
Recall: the break-even point is the number of units sold where NPV = $0.
Note: Think back to discussion of economic value added (EVA) in Chapter 4.
A project that breaks even on a present value basis will have a positive accounting profit but zero economic value added.
In other words, it will just cover all its costs, including the cost of capital.
Note: The NPV break-even level of sales will be greater than the accounting break-even level of sales. Why? 14

20. Operating Leverage
Operating Leverage - Degree to which costs are fixed.
Degree of Operating Leverage (DOL) - Percentage change in profits given a 1% change in sales.
Operating Leverage – Degree to which costs are fixed.
Degree of Operating Leverage (DOL) – Percentage change in profits given a 1% change in sales. 16

21. Operating Leverage: Why is it useful?
Operating Leverage – Degree to which costs are fixed.
Degree of Operating Leverage (DOL) – Percentage change in profits given a 1% change in sales. 6

22. Degree of Operating Leverage: Example
Operating Leverage – Degree to which costs are fixed.
Degree of Operating Leverage (DOL) – Percentage change in profits given a 1% change in sales. 18

23. Real Options Option to expand Option to abandon Timing option
Flexible production facilities
Real Options – Options to invest in, modify or dispose of a capital investment project 19

24. Real Options & the Value of Flexibility
Decision Trees – Diagram of sequential decisions and possible outcomes.
Decision trees help companies determine their options by showing various choices and outcomes.
The option to avoid a loss or produce extra profit has value.
The ability to create an option has value that can be bought or sold.
Decision Trees – Diagram of sequential decisions and possible outcomes. 19

25. Decision Trees: Example
Success
Test New Product (Invest $200,000)
Pursue project NPV=$2million
Failure
Stop project
NPV=0
Decision Trees – Diagram of sequential decisions and possible outcomes.
Don’t Test New Product
NPV=0