2. Chapter 11 Project Analysis and Evaluation 11.1Evaluating NPV Estimates 11.2Scenario and Other “What-if” Analyses 11.3Break-Even Analysis 11.4Operating Cash Flow, Sales Volume, and Break-Even 11.5Operating Leverage 11.6Additional Considerations in Capital Budgeting 11.7Summary and Conclusions Vigdis Boasson Mgf301, School of Management, SUNY at Buffalo

3. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.2 Evaluating NPV Estimates I: 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

4. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.3 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

5. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.4 Fairways Driving Range Example Fairways Driving Range expects rentals to be 20,000 buckets at $3 per bucket. Equipment costs are $20,000 depreciated using SL over 5 years and have a $0 salvage value. Variable costs are 10% of rentals and fixed costs are $45,000 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 (20k x $3):$60,000 Variable Costs (.10 x 60k): 6,000 Fixed Costs: 45,000 Depreciation (20k /5yrs): 4,000 EBIT: 5,000 Taxes (@15%) 750 Net Income $ 4,250

6. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.4 Fairways Driving Range Example (concluded) Estimated annual cash inflows: $5,000 + 4,000 - 750 = $8,250 r= 15%, t=5. The base-case NPV is: NPV = -I + C x {1 - [1/(1 + r) t ]}/r NPV = $-20,000 + ($8,250  {1 - [1/(1.15) 5 ]}/.15) = $7,654.

7. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.5 Fairways Driving Range Scenario Analysis INPUTS FOR SCENARIO ANALYSIS Scenario analysis: putting lower and upper bounds on cash flows. Poor revenues with high costs, high revenues with low costs. Base Case: Rentals are 20,000 buckets, variable costs are 10% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. Best Case: Rentals are 25,000 buckets, variable costs are 8% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. Worst Case: Rentals are 15,000 buckets, variable costs 12% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%.

8. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.5 Fairways Driving Range Best Case Scenario Best Case: Rentals are 25,000 buckets, variable costs are 8% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. Revenues (25k x $3):$75,000 Variable Costs (.08 x 75k): 6,000 Fixed Costs: 45,000 Depreciation (20k /5yrs): 4,000 EBIT: 20,000 Taxes (@15%) 3,000 Net Income $ 17,000 OCF = EBIT + Dep. - Taxes = 20,000 + 4,000 - 3,000 = 21,000

9. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.5 Fairways Driving Range:Worst Case Scenario Worst Case: Rentals are 15,000 buckets, variable costs 12% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. Revenues (15k x $3): $45,000 Variable Costs (.12 x 45k): 5,400 Fixed Costs: 45,000 Depreciation (20k /5yrs): 4,000 EBIT: -9,400 Taxes (@15%) 0 Net Income $ -9,400 OCF = EBIT + Dep. - Taxes = -9,400 + 4,000 - 0 = -5,400

10. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.5 Fairways Driving Range Scenario Analysis (concluded) Scenario Rentals( units ) Revenues Net Income Cash Flow Best Case25,000 $75,000 $17,000 $21,000 Base Case20,000 60,000 4,250 8,250 Worst Case15,00045,000 -9,400 -5,400 Note that the worst case results in a tax credit. This assumes that the owners had other income against which the loss is offset.

11. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.6 Fairways Driving Range Sensitivity Analysis INPUTS FOR SENSITIVITY ANALYSIS Sensitivity analysis: hold all projections constant except one, alter that one, and see how sensitive cash flow is to that one when it changes - the point is to get a fix on where forecasting risk may be especially severe. Base Case: Rentals are 20,000 buckets, variable costs are 10% of revenues, fixed costs are $45,000, 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 15,000 buckets and revenues are $45,000. All other variables are unchanged.

12. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.6 Fairways Driving Range : Best Case Sensitivity Analysis Best Case: Rentals are 25,000 buckets, variable costs are 10% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. Revenues (25k x $3):$75,000 Variable Costs (.10 x 75k): 7,500 Fixed Costs: 45,000 Depreciation (20k /5yrs): 4,000 EBIT: 18,500 Taxes (@15%) 2,775 Net Income $ 15,725 OCF = EBIT + Dep. - Taxes = 18,500 + 4,000 - 2,775 = 19,725 NPV = $-20,000 + ($19,725  {1 - [1/(1.15) 5 ]}/.15) = $46,121.

13. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.6 Fairways Driving Range :Worst Case Sensitivity Analysis Worst Case: Rentals are 15,000 buckets, variable costs are 10% of revenues, fixed costs are $45,000, depreciation is $4,000 per year, and the tax rate is 15%. Revenues (15k x $3): $45,000 Variable Costs (.10 x 45k): 4,500 Fixed Costs: 45,000 Depreciation (20k /5yrs): 4,000 EBIT: -8,500 Taxes (@15%) 1,275 Net Income -$ 7,225 OCF = EBIT + Dep. - Taxes = -8,500 + 4,000 + 1,275 = -3,225 *Assume a tax credit is created in the worst case. NPV = $-20,000 + (-3,225  {1 - [1/(1.15) 5 ]}/.15) = -$30,811.

14. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.6 Fairways Driving Range Sensitivity Analysis (concluded) Scenario Rentals Revenues Net Income Cash Flow NPV Best Case 25,000 $75,000$15,725 $19,725 $ 46,121 Base Case 20,000 60,000 4,250 8,250 $ 7,655 Worst Case 15,000 45,000 -7,225 -3,225 -$30,811 Note that the worst case results in a tax credit. This assumes that the owners had other income against which the loss is offset.

15. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.7 Fairways Driving Range: Rentals vs. NPV Fairways Sensitivity Analysis - Rentals vs. NPV Base case NPV = $7,655 NPV Worst case NPV = -$30,811 Rentals per Year Best case NPV = $46,121 0 -$60,000 15,000 25,000 20,000 $60,000 x x x

16. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.8 Fairways Driving Range: Total Cost Calculations TC = VC + FC TC = (Q x v ) + FC RentalsVariable CostFixed CostTotal Cost 0 $0$45,000 $45,000 15,000 4,500 45,000 49,500 20,000 6,000 45,000 51,000 25,000 7,500 45,000 52,500

17. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.9 Fairways Driving Range: Break-Even Analysis Fairways Break-Even Analysis - Sales vs. Costs and Rentals Break-Even Point 18,148 Buckets Sales and Costs Rentals per Year $50,000 $20,000 15,000 25,000 20,000 $80,000 Total Revenues Fixed Costs + Dep $49,000 Net Income > 0 Net Income < 0

18. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.10 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) = ($45,000 + 4,000)/($3.00 -.30) = 18,148 buckets

19. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.11 Chapter 11 Example Assume you have the following information: Price = $5 per unit; variable costs = $3 per unit Fixed operating costs = $10,000 Initial cost is $20,000 5 year life; straight-line depreciation to 0, no salvage value Assume no taxes Required return = 20%

20. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.11 Chapter 11 Example Break-Even Computations A. Accounting Break-Even Q = (FC + D)/(P - v) = ($10,000 + $4,000)/($5 - 3) = 7,000 units. EBIT = 5 x 7,000 - 3 x 7,000 - 10,000 - 4,000) = 0 OCF = 0 + 4,000 - 0 = 4,000 r = 20% t = 5 years Initial cost = $20,000 IRR = 0 ; NPV = -$8,038

21. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.11 Chapter 11 Example Break-Even Computations B. Cash Break-Even Q = FC/(P - v) = $10,000/($5 - 3) = 5,000 units. EBIT = 5 x 5,000 - 3 x 5,000 - 10,000 - 4,000) = -4,000 OCF = -4,000 + 4,000 - 0 = 0 r = 20% t = 5 years Initial cost = $20,000 IRR = -100% ; NPV = -$20,000

22. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.11 Chapter 11 Example C. Financial Break-Even Q = (FC + OCF)/(P - v), where OCF is the level of OCF that results in a zero NPV. A project that breaks even on a financial basis has a discounted payback equal to its life, a zero NPV, and IRR just equal to the required return. NPV = -I + C x {1 - [1/(1 + r) t ]}/r C x {1 - [1/(1 + r) t ]}/r = NPV + I NPV = 0, r = 20%, t = 5 years, Initial cost = $20,000 C x {1 - [1/(1.20 5 ]}/.20 = 0 + 20,000 C x 2.9906 = 20,000 C = 20,000 / 2.9906 = 6,688 Q = (FC + OCF)/(P - v)=($10,000 + 6,688)/($5 - 3) = 8,344 units IRR = 20% ; NPV = 0, Payback=5 years.

23. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.12 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. III.The Cash Break-Even Point Q = FC/(P - v) At the Cash BEP, OCF = 0. IV.The Financial Break-Even Point Q = (FC + OCF * )/(P - v) At the Financial BEP, NPV = 0. (OCF* is the OCF at which NPV = 0.)

24. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.13 Fairways Driving Range: Degree of Leverage (DOL) DOL is a “multiplier” which measures the effect of a change in quantity sold on OCF. %  in OCF = DOL  %  in Q DOL = 1 + FC/OCF For Fairways, let Q = 20,000 buckets. Ignoring taxes, OCF = $9,000 and fixed costs = $45,000. Fairway’s DOL = 1 + FC/OCF = 1 + $45,000/$9,000 = 6.0. In other words, a 10% increase (decrease) in quantity sold will result in a (6 x 10%) = 60% increase (decrease) in OCF. 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.

25. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.14 Managerial Options and Capital Budgeting Managerial options and capital budgeting  What is ignored in a static DCF analysis? Management’s ability to modify the project as events occur.  Contingency planning 1.The option to expand 2.The option to abandon 3.The option to wait  Strategic options Possible future investments that may result from an investment under consideration. Generally, the exclusion of managerial options from the analysis causes us to underestimate the “true” NPV of a project.

26. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.15 Capital Rationing Capital rationing  Definition: The situation in which the firm has more good projects than money.  Soft rationing - limits on capital investment funds set within the firm.  Hard rationing - limits on capital investment funds set outside of the firm (i.e., in the capital markets).

27. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.17 Solution to Problem 11.1 BetaBlockers, Inc. (BBI) manufactures sunglasses. The variable material cost is $0.63 per unit and the variable labor cost is $2.02 per unit. a. What is the variable cost per unit? VC = variable material cost + variable labor cost = $0.63 + $2.02 = $2.65 b. Suppose BBI incurs fixed costs of $415,000 during a year when production is 250,000 units. What are total costs for the year? TC = total variable costs + fixed costs = ($2.65)(250,000) + $ 415,000 = $ 1,077,500

28. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.17 Solution to Problem 11.1 (concluded) c. If the selling price is $5.50 per unit, does BBI break even on a cash basis? If depreciation is $150,000, what is the accounting break- even point? Q cash = (FC ) / (P - v) = $415,000/($5.5 - $ 2.65) = 145,614 units Q account = (FC + Dep) / (P - v) = ($415,000 + $ 150,000)/($5.50 - $2.65) = 198,246 units

29. Vigdis Boasson MGF301, School of Management, SUNY at Buffalo 11.18 Solution to Problem 11.13 A proposed project has fixed costs of $25,000 per year. OCF at 4,000 units is $60,000. 1. Ignoring taxes, what is the degree of operating leverage (DOL)? DOL = 1 + FC/OCF = 1 + ($25,000/$60,000) = 1.4167 2. If quantity sold rises from 7,000 to 7,300, what will the increase in OCF be? %  Q = (7,300 - 7,000)/7,000 = 4.29% %  OCF = DOL(%  Q) =1.4167 x 4.29% = 6.07% New OCF = ($60,000)(1.0607) = $63,642 3. What is the new DOL? DOL at 7,300 units = 1 + ($25,000/$63,642) = 1.3928