1. 9-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Nine Project Analysis and Evaluation

2. 9-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 9.1Evaluating 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 Summary and Conclusions Chapter Organisation

3. 9-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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. 9-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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). What sources of value create the estimated NPV?

5. 9-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Scenario and Other ‘What If’ Analysis Getting started –Estimate NPV based on initial cash flow projections. Scenario analysis –The determination of what happens to NPV estimates when we ask ‘what if’ questions. Sensitivity analysis –Investigation of what happens to NPV when only one variable is changed. Simulation analysis –A combination of scenario and sensitivity analysis used to construct a distribution of possible NPV estimates.

6. 9-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Fairways Driving Range 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. 9-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Fairways Example—Net Profit

8. 9-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Fairways Example—Getting Started 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. 9-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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 $4,000 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 $4,000 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 $4,000 p.a.

10. 9-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Fairways Example—Scenario Analysis

11. 9-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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 $4,000 p.a. Best case: Rentals are 25,000 buckets p.a. All other variables are the same as the base case. Worst case: Rentals are 18,000 buckets p.a. All other variables are the same as the base case.

12. 9-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Fairways Example—Sensitivity Analysis

13. 9-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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. 9-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Simulation Analysis An extended version of scenario analysis that uses probability distributions and considers the interrelationships between variables. Usually performed with computer programs. Program selects values for each variable and calculates NPV. This process is repeated many times. End result: Probability distribution of NPV based on a sample of 1,000 or more values. Use is becoming more common, particularly for large-scale projects.

15. 9-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Simulation Analysis – Sample Output Output shows that there is a less than 50% chance that the NPV will be positive.

16. 9-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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.

17. 9-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Fixed, Variable and Total Costs Variable costs: –Variable costs change when the quantity of output changes –Total variable costs = quantity × cost per unit Fixed costs: –Fixed costs are constant, regardless of output, over some time period Total costs: –Total Costs = fixed + variable = FC + vQ

18. 9-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Fixed, Variable and Total Costs Your firm pays $8,000 per month in fixed costs. You also pay $3 per unit to produce your product. What is the total cost if you produce 1,000 units? What about 5,000? 10,000? Total cost if you produce 1,000 units = 8,000 + 3(1,000) = $11,000 Total cost if you produce 5,000 units = 8,000 + 3(5,000) = $23,000 Total cost if you produce 10,000 units = 8,000 + 3(10,000) = $38,000

19. 9-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Output Level and Total Costs

20. 9-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Average versus Marginal Cost Average Cost –TC/number of units –Decreases as number of units increases. Marginal Cost –The cost to produce one more unit –Same as variable cost per unit

21. 9-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Average versus Marginal Cost Example: What is the average cost and marginal cost under each situation in the previous example? Produce 1,000 units: Average = $11,000/1,000 = $11 Produce 5,000 units: Average = $23,000/5000 = $4.60 Produce 10,000 units: Average = $38,000/10,000 = $3.80 Marginal cost of producing one more unit is $3.

22. 9-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Accounting 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 Note: At accounting break-even, net income = 0, NPV is negative and IRR =0.

23. 9-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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.

24. 9-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Fairways Example—Accounting Break-even Analysis

25. 9-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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.

26. 9-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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

27. 9-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Other Break-even Measures 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.

28. 9-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Fairways Example—Break-even Measures

29. 9-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Operating Leverage The degree to which a firm or project is committed to its fixed costs. The degree of operating leverage (DOL) is the percentage change in operating cash flow relative to the percentage change in quantity sold.

30. 9-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Operating Leverage (continued) 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.

31. 9-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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.

32. 9-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Managerial Options A static DCF analysis ignores management’s ability to modify the project as events occur. Managerial options are opportunities that managers can exploit if certain things happen in the future. There are a great number of these options. For example, a product’s pricing, manufacturing and advertising can all be changed after the product is launched.

33. 9-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Contingency Planning Contingency planning takes into account the managerial options that are implicit in a project. The broad classes of options are: –The option to expand –The option to abandon –The option to wait –Strategic options (e.g. ‘toe hold’ investments, and research and development).

34. 9-34 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Capital Rationing A situation that exists if a firm has positive NPV projects but cannot find the necessary financing. Soft rationing occurs when units in a business are allocated a certain amount of financing for capital budgeting. Hard rationing occurs when the firm is unable to raise the financing for a project under any circumstances.

35. 9-35 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions Errors in projected future cash flows lead to misleading NPVs. This is forecasting risk. Scenario and sensitivity analysis help identify variables critical to a project. Break-even analysis in its various forms is useful for identifying critical sales levels. Operating leverage is a key determinant of break- even levels. Projects usually have future managerial options associated with them. Capital rationing occurs when profitable projects cannot be funded.