F305 Intermediate Corporate Finance Indiana University Class 5

Project Analysis – Managerial Options  While planning is essential, things rarely work out as planned! So, what if: We miss sales projections Timing is not what was expected A project is wildly successful Effect on other products is unexpected The economy has changed The discount rate changes Cost estimates are incorrect  The Case of Daimler-Chrysler

What Are Management’s Options? The company can postpone (Timing Option) Scale back or abandon Build in flexibility Expand or duplicate Strategic options  Test market  Small scale tests

The Timing Option Most attractive when:  Uncertainty is large  Immediate project cash flows are small The Abandonment Option Treated as an Option in investments  Provides partial insurance against failure  Similar to a Put option, with the exercise price equal to the value of the project’s assets if they were sold or shifted to a more valuable use  So, provides a means to assign an abandonment value to the cash flow and arrive at a value including abandonment

Built-in Flexibility  Is a project convertible to alternative uses? Inputs Outputs Expansion  Each alternative is assigned a probability to arrive at an overall NPV for the flexible project  Option to expand a project not built in to the original plan

What if? Scenario Analysis – allows the analyst to change multiple variables at once. If many conditions change, what is the effect on the project analysis Sensitivity Analysis – how sensitive is the analysis to single factor fluctuation? Break Even Analysis  The trade off between fixed costs and variable costs  Accounting break-even

Break Even Analysis Consider the following two cost structures  FC (A) + VC (A) * Q where FC = 40,000 and variable costs are $0.30  FC (B) + VC (B) * Q where FC = 60,000 and variable costs are $0.15  At what point are we indifferent to the cost structure?  If Cost structure A had Q = 20,000, how many additional units would have to be sold under cost structure B to make the two cost structures comparable?

Break Even Analysis Consider the following variables  P = price per unit  v = variable cost per unit  Q = number of units sold  FC = fixed costs  D = depreciation  T = tax rate Then  B/E Q = (FC + D) / (P – v)  Q = (40,000+4,000) / ($ $.30)