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.

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

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

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

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

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

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

Sensitivity Analysis - Example Possible Range of Variables 9

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 = $14,000 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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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