Ch11. Project Analysis and Evaluation

1) Scenario and other what-if analyses Actual cash flows and projected cash flows. Forecasting risks (estimation risks): errors in projected cash flows will lead to incorrect decisions. (1) Scenario analysis. In order to handle the possible errors in estimating cash flows, re-estimate cash flows or others under various circumstances/economic scenario.

Ex) The project costs $200,000 and has a 5-year life. It does not have salvage value. Straight-line depreciation is applied. The required rate is 12% and tax rate is 34%

2) Sensitivity analysis Analysis to figure out a key determinant to estimates in analysis, assuming other variables are constant. Among the variables, sale is usually found more significant than others.

3) Simulation analysis: A combination of scenario and sensitivity analyses. 4) Break-Even Analysis Variable costs (VC): costs that change when the quantity of output changes. Ex) direct labor costs and raw material costs. VC = v × Q

Fixed costs (FC): costs that do not change when the quantity of output changes during a particular time period. Total costs = VC + FC = v × Q + FC Marginal or incremental costs: change in costs that occurs when there is a small change in output. 5) Accounting Break-Even A tool for analyzing the relationship between sales volume and profitability. Sales or quantity making EBIT (or Net Income without considering interest) equal to zero.

EBIT = Sale – VC – FC – D Net Income = (Sale – VC – FC – D) × (1-t) If EBIT or Net Income =0, then Sale –VC – FC-D = s × q - v × q – FC – D = 0. q = (FC + D) / (s - v). 6) Operating cash flow, sales volume and break-even.

Ex) Wettyway sailboat CO considering whether to launch its new Margo-class sailboat. The selling price will be $40,000 per boat. Variable cost per boat is $20,000. Annual Fixed costs is $500,000. Total investment to launch the project is $3,500,000. It would be depreciated straight line to zero over five years. Salvage value is zero. There are no working capital consequences. 20% required rate of return on new project is expected. Wettyway forecasts about 85 boat sales in a year. Ignore tax

Operating cash flow = EBIT + depreciation – tax = (Sale –Variable costs – Fixed costs –Depreciation) +Depreciation - 0 = 85*(40,000-20,000)-500,000 = 1,200,000 per year. NPV with 20% and 5 year = 1,200,000*(1-1/(1+0.2)^5)/0.2-3,500,000 =88,735

Break-even: (FC + D) / (p - v) = (500, ,500,000/5) / (40,000-20,000) = 60. Thus this project looks good. At break even, 1) operating cash flow under assumptions is only depreciation. OCF = 60*(40,000-20,000)-500, ,500,000/5 + 3,500,000/5 =700,000. NPV with 20% = -1,406,572. 2) IRR = 0. Ex) 3,500,000 = 700,000/(1+IRR) + 700,000/(1+IRR)^2+ ….+700,000/(1+IRR)^5. 3) Life of the project is a payback period. Thus if a project’ s performance is better than break even, IRR would be positive and payback period is shorter than the life of the project.

7) Relationship between operating cash flows and break even point (quantity:q). OCF = (Sale – Variable costs – Fixed costs – Depreciation) + Depreciation – Tax (ignored) = (p-v) * q – FC q = (FC + OCF) / (p-v), What does it mean? Here (1) accounting break-even (q) means zero net income or EBIT. In that case, OCF is a depreciation. q= (500, ,500,000/5) / (40,000-20,000) = 60 (2) Cash break-even (q) means the sales level that results in a zero OCF. q covers only Fixed costs. In that case OCF is 0. q= (500, ) / (40,000-20,000) = 25

(3) Financial break-even (q) mean zero NPV. In order to calculate financial break-even, at first we have to calculate a periodic payment of an annuity (operating cash flows) that would make PV of the annuity equal to initial investment. 3,500,000 = payment * (1-1/(1.2^5))/0.2 Payment (operating cash flow) = 1,170,329 q= (500, ,170,329) / (40,000-20,000) = 83.5 Thus financial break-even is much higher than accounting break-even.

8) Operating leverage. Def: the degree to which a project or firm is committed to fixed production costs. The fixed costs can act like a lever in the sense that small change in revenue can be magnified into a large percentage change in operating cash flow and NPV. The higher the degree of operating leverage, the greater the forecasting risk. Thus managers try to reduce the operating leverage through outsourcing the project.

How to measure the operating leverage, degree of operating leverage (DOL)? Percentage change in OCF = DOL × Percentage change in q. Here OCF = (Sale – Variable costs – Fixed costs – Depreciation) + Depreciation – Tax (ignored) = (p-v) * q – FC. Thus one unit change in q will increase (p-v) in OCF. Percentage change in OCF = DOL × Percentage change in q. (p-v) / OCF = DOL × 1 / q DOL = (p-v) × q / OCF Here, OCF +FC = (p-v) × q Thus DOL = 1 + FC / OCF

Ex) Wettyway sail boat case, at q =50. DOL = 1+500,000/[(40,000-20,000) × ,000)] =2. It means that at q=50 level, 1% increase in quantity will increase 2% in OCF.

Here operating degree of operating leverage (DOL) is influenced by fixed and variable costs. Depending on a choice of subcontracting projects, fixed and variable costs changes and then DOL will change too.

9) Capital Rationing: The situation that exists if a firm has positive NPV projects but can not find the necessary financing. 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 can not raise financing for a project under any circumstances.