1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-1 Chapter Nine Project Analysis and Evaluation

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-2 9.1 Evaluating NPV Estimates 9.2 Scenario and Other ‘What If’ Analysis 9.3 Break-even Analysis 9.4 Operating Cash Flow, Sales Volume and Break-even 9.5 Operating Leverage 9.6 Additional Considerations in Capital Budgeting 9.7 Summary and Conclusions Chapter Organisation

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-3 Chapter Objectives Understand and apply scenario analysis, sensitivity analysis and simulation analysis to capital project evaluation. Apply break-even analysis, distinguishing between accounting break-even, cash break-even and financial break-even. Measure the degree of operating leverage of a firm. Discuss the various managerial options in capital budgeting. Outline capital rationing and the difference between soft and hard rationing.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-4 Evaluating NPV Estimates The basic problem: How reliable is our NPV estimate? Projected cash flows are based on a distribution of possible outcomes each period: resulting in an ‘average’ cash flow. Forecasting risk: the possibility of an incorrect decision due to errors in cash flow projections (GIGO system). Ask: What sources of value create the estimated NPV?

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-5 Scenario and Other ‘What If’ Analysis Base case estimation – Estimated NPV based on initial cash flow projections. Scenario analysis – Examine effect on NPV of best-case and worst-case scenarios. Sensitivity analysis – Examine effect on NPV by changing only one input variable. Simulation analysis – Vary several input variables simultaneously to construct a distribution of possible NPV estimates.

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-6 Fairways Driving Range Example Fairways Driving Range expects annual rentals to be 20 000 buckets at $3 per bucket. Equipment costs $20 000 and is depreciated using the straight-line method over five years to a zero salvage value. Variable costs are 10 per cent of rentals income and fixed costs are $40 000 per year. Assume no increase in working capital and no additional capital outlays. The required rate of return is 15 per cent and the tax rate is 30 per cent.

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-7 Fairways Example—Net Profit

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-8 Fairways Example—Base Case NPV Estimated annual cash flow: $10 000 + $4000 – $3000 = $11 000 At 15%, the 5-year annuity factor is 3.3522. The base case NPV is then: NPV = – $20 000 + ($11 000 × 3.3522) = $16 874

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-9 Fairways Example—Scenario Analysis Inputs for scenario analysis: Base case: Rentals are 20 000 buckets p.a., variable costs are 10 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a. Best case: Rentals are 25 000 buckets p.a., variable costs are 8 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a. Worst case: Rentals are 18 000 buckets p.a., variable costs are 12 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a.

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-10 Fairways Example—Scenario Analysis

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-11 Fairways Example—Sensitivity Analysis Inputs for sensitivity analysis: Base case: Rentals are 20 000 buckets p.a., variable costs are 10 per cent of rental income, fixed costs are $40 000, depreciation is $4000 p.a. Best case: Rentals are 25 000 buckets p.a. All other variables are unchanged. Worst case: Rentals are 18 000 buckets p.a. All other variables are unchanged.

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-12 Fairways Example—Sensitivity Analysis

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-13 Base case NPV = $16 874 NPV Worst case NPV = $4 202 Rentals per Year Best case NPV = $48 552 0 –$60 000 15 00025 00020 000 $60 000 x x x Fairways Example—Sensitivity Analysis

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-14 Break-even Analysis Useful for analysing the relationship between sales volume and profitability. Break-even point is the sales volume at which the present value of the project’s cash inflows and outflows are equal  NPV = 0. Important distinction between variable costs and fixed costs. Accounting break-even is the sales volume that results in a zero net profit.

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-15 Fixed and Variable Costs There are two types of costs that are important in break-even analysis: variable and fixed. -Variable costs change when the quantity of output changes -Total variable costs= quantity × cost per unit - Fixed costs are constant, regardless of output, over some time period - Total Costs = fixed + variable = FC + vQ Example: Your firm pays $3000 per month in fixed costs. You also pay $15 per unit to produce your product. (Total cost if you produce 1000 units = 3000 + 15(1000) = 18 000) (Total cost if you produce 5000 units = 3000 + 15(5000) = 78 000)

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-16 Average versus Marginal Cost Average Cost - TC/number of units - Will decrease as number of units increases Marginal Cost - The cost to produce one more unit - Same as variable cost per unit Example: What is the average cost and marginal cost under each situation in the previous example? - Produce 1000 units: Average = 18 000/1000 = $18 - Produce 5000 units: Average = 78 000/5000 = $15.60

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-17 Fairways Example—Accounting Break-even Analysis

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-18 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’n = $44 000 Net Income < 0 Net Income > 0 20 000 Total accounting costs Fairways Example—Accounting Break-even Analysis

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-19 Fairways Example—Accounting Break-even Analysis Solve algebraically for break-even quantity (Q): If sales do not reach 16 296 buckets, Fairways will incur losses in both the accounting sense and the financial sense.

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-20 Accounting of Break-even Point General expression Q = (FC + D)/(P – v) where: Q = total units sold FC = total fixed costs D = depreciation P = price per unit v = variable cost per unit

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-21 Using Accounting Break-even Accounting break-even is often used as an early- stage screening number. If a project cannot break even on an accounting basis, then it is not going to be a worthwhile project. Accounting break-even gives managers an indication of how a project will impact accounting profit.

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-22 Summary of Break-even Measures Accounting break-even – Q = (FC + D)/(P – v) – At accounting break-even, net income = 0, NPV is negative and IRR =0. Cash break-even – Q = FC/(p – v) – At cash break-even, OCF = 0, NPV is negative and IRR = –100%. Financial break-even – Q = (FC + OCF)/(P – v) – At financial break-even, NPV = 0 and IRR = required return.

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-23 Fairways Example—Break-even Measures

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-24 Operating Leverage The degree to which a firm is committed to its fixed costs. The higher the degree of operating leverage, the greater the danger from forecasting risk. The lower the degree of operating leverage, the lower the break-even point. DOL depends on the current sales level.

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-25 Fairways Example—DOL Let Q = 20 000 buckets and, ignoring taxes, OCF = $14 000 and FC = $40 000. A 10 per cent increase (decrease) in quantity sold will result in a 38.57 per cent increase (decrease) in OCF. Note: Higher DOL equals greater volatility (risk) in OCF and leverage is a two-edged sword—sales decreases will be magnified as much as increases.

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-26 Managerial Options and Capital Budgeting A static DCF analysis ignores management’s ability to modify the project as events occur. Contingency planning – The option to expand. – The option to abandon. – The option to wait. Strategic options – ‘Toe hold’ investments. – Research and development.

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 9-27 Capital Rationing A condition which prevents management from undertaking all acceptable projects because of a shortage of funds. Soft rationing occurs when management limits the amount that can be invested in new projects during some specified time period. Hard rationing occurs when the firm is unable to raise the financing for a project.