Chapters Outline Prepared by: Thomas J. Cottrell Modified by: Carlos Vecino HEC-Montreal Chapter 9 Net Present Value and Other Investment Criteria 9.1Net Present Value Chapter 10 Making Capital Investment Decisions 10.1Project Cash Flows: A First Look 10.2Incremental Cash Flows 10.3Pro Forma Financial Statements and Project Cash Flows Chapter 11 Project Analysis and Evaluation 11.3Break-Even Analysis 11.4Operating Cash Flow, Sales Volume, and Break-Even 11.5Operating Leverage Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd.

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 2 NPV Illustrated Assume you have the following information on Project X: Initial outlay -$1,100Required return = 10% Annual cash revenues and expenses are as follows: Year Revenues Expenses 1 $1,000 $ ,000 1,000 Draw a time line and compute the NPV of project X.

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 3 NPV Illustrated (concluded) Initial outlay ($1,100) Revenues$1,000 Expenses500 Cash flow$500 Revenues$2,000 Expenses1,000 Cash flow$1,000 – $1, $ $500 x $1,000 x NPV

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 4 Underpinnings of the NPV Rule Why does the NPV rule work? And what does “work” mean? Look at it this way: A “firm” is created when securityholders supply the funds to acquire assets that will be used to produce and sell a good or a service; The market value of the firm is based on the present value of the cash flows it is expected to generate; Additional investments are “good” if the present value of the incremental expected cash flows exceeds their cost; Thus, “good” projects are those which increase firm value - or, put another way, good projects are those projects that have positive NPVs! Moral of the story: Invest only in projects with positive NPVs.

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 5 Fundamental Principles of Project Evaluation Fundamental Principles of Project Evaluation: Project evaluation - the application of one or more capital budgeting decision rules to estimated relevant project cash flows in order to make the investment decision. Relevant cash flows - the incremental cash flows associated with the decision to invest in a project. The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project. Stand-alone principle - evaluation of a project based on the project’s incremental cash flows.

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 6 Example: Preparing Pro Forma Statements Suppose we want to prepare a set of pro forma financial statements for a project for Norma Desmond Enterprises. In order to do so, we must have some background information. In this case, assume: 1.Sales of 10,000 $5/unit. 2.Variable cost per unit is $3. Fixed costs are $5,000 per year. The project has no salvage value. Project life is 3 years. 3.Project cost is $21,000. Depreciation is $7,000/year. 4.Additional net working capital is $10, The firm’s required return is 20%. The tax rate is 34%.

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 7 Example: Preparing Pro Forma Statements (continued) Pro Forma Financial Statements Projected Income Statements Sales$______ Var. costs______ $20,000 Fixed costs5,000 Depreciation7,000 EBIT$______ Taxes (34%)2,720 Net income$______

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 8 Example: Preparing Pro Forma Statements (continued) Pro Forma Financial Statements Projected Income Statements Sales$50,000 Var. costs30,000 $20,000 Fixed costs5,000 Depreciation7,000 EBIT$ 8,000 Taxes (34%)2,720 Net income$ 5,280

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 9 Example: Preparing Pro Forma Statements (concluded) Projected Balance Sheets 0123 NWC$______$10,000$10,000$10,000 NFA21,000____________0 Total$31,000$24,000$17,000$10,000

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 10 Example: Preparing Pro Forma Statements (concluded) Projected Balance Sheets 0123 NWC$10,000$10,000$10,000$10,000 NFA21,00014,0007,0000 Total$31,000$24,000$17,000$10,000

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 11 Example: Using Pro Formas for Project Evaluation Now let’s use the information from the previous example to do a capital budgeting analysis. Project operating cash flow (OCF): EBIT$8,000 Depreciation+7,000 Taxes-2,720 OCF$12,280

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 12 Example: Using Pro Formas for Project Evaluation (continued) Project Cash Flows 0123 OCF$12,280$12,280$12,280 Chg. NWC____________ Cap. Sp.-21,000 Total______$12,280$12,280$______

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 13 Example: Using Pro Formas for Project Evaluation (continued) Project Cash Flows 0123 OCF$12,280$12,280$12,280 Chg. NWC-10,00010,000 Cap. Sp.-21,000 Total-31,000$12,280$12,280$22,280

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 14 Example: Using Pro Formas for Project Evaluation (concluded) Capital Budgeting Evaluation: NPV = -$31,000 + $12,280/ $12,280/ $22,280/ = $655 IRR = 21% Should the firm invest in this project? Why or why not? Yes -- the NPV > 0, and the IRR > required return

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 15 Evaluating NPV EstimatesI: The Basic Problem The basic problem: How reliable is our NPV estimate?  Projected vs. Actual cash flows Estimated cash flows are based on a distribution of possible outcomes each period  Forecasting risk The possibility of a bad decision due to errors in cash flow projections - the GIGO phenomenon  Sources of value What conditions must exist to create the estimated NPV? “What If” analysis A.Scenario analysis B.Sensitivity analysis

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 16 Evaluating NPV Estimates II: Scenario and Other “What-If” Analyses Scenario and Other “What-If” Analyses  “Base case” estimation Estimated NPV based on initial cash flow projections  Scenario analysis Posit best- and worst-case scenarios and calculate NPVs  Sensitivity analysis How does the estimated NPV change when one of the input variables changes?  Simulation analysis Vary several input variables simultaneously, then construct a distribution of possible NPV estimates

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 17 T11.12 Summary of Break-Even Measures (Table 11.1) I.The General Expression Q = (FC + OCF)/(P - V) where:FC = total fixed costs P = Price per unit v = variable cost per unit II.The Accounting Break-Even Point Q = (FC + D)/(P - V) At the Accounting BEP, net income = 0, NPV is negative, and IRR of 0. III.The Cash Break-Even Point Q = FC/(P - V) At the Cash BEP, operating cash flow = 0, NPV is negative, and IRR = -100%. IV.The Financial Break-Even Point Q = (FC + OCF * )/(P - V) At the Financial BEP, NPV = 0 and IRR = required return.

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 18 Fairways Driving Range Example Fairways Driving Range expects rentals to be 20,000 buckets at $3 per bucket. Equipment costs $20,000 and will be depreciated using SL over 5 years and have a $0 salvage value. Variable costs are 10% of rentals and fixed costs are $40,000 per year. Assume no increase in working capital nor any additional capital outlays. The required return is 15% and the tax rate is 15%. Revenues$60,000 Variable costs 6,000 Fixed costs 40,000 Depreciation 4,000 EBIT $10,000 Taxes 1500 Net income $ 8,500

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 19 Fairways Driving Range Sensitivity Analysis INPUTS FOR SENSITIVITY ANALYSIS Base case: Rentals are 20,000 buckets, variable costs are 10% of revenues, fixed costs are $40,000, depreciation is $4,000 per year, and the tax rate is 15%. Best case: Rentals are 25,000 buckets and revenues are $75,000. All other variables are unchanged. Worst case: Rentals are 18,000 buckets and revenues are $54,000. All other variables are unchanged.

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 20 T11.6 Fairways Driving Range Sensitivity Analysis (concluded) Net Project ScenarioRentals Revenues income cash flow NPV Best case25,000 $75,000 $19,975 $23,975 $60,364 Base case20,000 60,000 8,500 12,50021,900 Worst case18,000 54,000 3,910 7,910 6,514

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 21 Fairways Driving Range: Rentals vs. NPV Fairways Sensitivity Analysis - Rentals vs. NPV Base case NPV = $21,900 NPV Worst case NPV = $3,437 Rentals per Year Best case NPV = $60, $60,000 15,00025,00020,000 $60,000 x x x

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 22 Total Cost = Variable cost + Fixed cost Variable Fixed Total Total Rentals Revenue cost cost cost Depr. acct. cost 0 $0 $0 $40,000 $40,000 $4,000$44,000 15,000 45,000 4,500 40,000 44,500 4,000 48,500 20,000 60,000 6,000 40,000 46,000 4,000 50,000 25,000 75,000 7,500 40,000 47,500 4,000 51,500 Fairways Driving Range: Total Cost Calculations

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 23 Fairways Driving Range: Break-Even Analysis Fairways Break-Even Analysis - Sales vs. Costs and Rentals Accounting break-even point 16,296 Buckets Rentals per Year $50,000 $20,000 15,000 25,000 $80,000 Total revenues Fixed costs + Dep $44,000 Net Income < 0 Net Income > 0 20,000

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 24 Fairways Driving Range: Accounting Break-Even Quantity Fairways Accounting Break-Even Quantity (Q) Q = (Fixed costs + Depreciation)/(Price per unit - Variable cost per unit) = (FC + D)/(P - V) = ($40, ,000)/($ ) = 16,296 buckets If sales do not reach 16,296 buckets, the firm will incur losses in both the accounting sense and the financial sense.

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 25 Operating Leverage Basic Idea: “Operating Leverage” is the degree to which a project or a firm relies on fixed production costs. Measuring Operating Leverage: If the quantity sold rises by X%, what will be the percentage change in operating cash flow? This percentage change (%  ) in Operating Cash Flow (OCF) is called the Degree of Operating Leverage (DOL). Percentage change (%  ) in OCF = DOL x Percentage change (%  ) in Q DOL = 1 + (Fixed Costs / OCF)

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 26 Fairways Driving Range DOL Since %  in OCF = DOL  %  in Q, DOL is a “multiplier” which measures the effect of a change in quantity sold on OCF. For Fairways, let Q = 20,000 buckets. Ignoring taxes, OCF = $14,000 and fixed costs = $40,000, and Fairway’s DOL = 1 + FC/OCF = 1 + $40,000/$14,000 = In other words, a 10% increase (decrease) in quantity sold will result in a 38.57% increase (decrease) in OCF. Two points should be kept in mind:  Higher DOL suggests greater volatility (i.e., risk) in OCF;  Leverage is a two-edged sword - sales decreases will be magnified as much as increases.