Ch11. Project Analysis and Evaluation

1
Ch11. Project Analysis and Evaluation
2
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.

3

• 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

4

• 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.

5

• 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

6

• 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.

7

• 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.

8

• 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

9

• 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/(10.2)5)/0.2-3,500,000 88,735

10

• Break-even (FC D) / (p - v) (500,000
  3,500,000/5) / (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)-500,000
  -3,500,000/5 3,500,000/5 700,000.
• NPV with 20 -1,406,572.
• 2) IRR 0.
• Ex) 3,500,000 700,000/(1IRR)
  700,000/(1IRR)2 .700,000/(1IRR)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.

11

• 7) Relationship between operating cash flows and
  break even point (quantityq).
• 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 (500,000 3,500,000/5) / (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 (500,000 0) / (40,000-20,000) 25

12

• (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/(1.25))/0.2
• Payment (operating cash flow) 1,170,329
• q (500,000 1,170,329) / (40,000-20,000) 83.5
• Thus financial break-even is much higher than
  accounting break-even.

13

• 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.

14
(No Transcript)
15
(No Transcript)
16

• 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

17

• Ex) Wettyway sail boat case, at q 50.
• DOL 1500,000/(40,000-20,000) 50-500,000)
  2.
• It means that at q50 level, 1 increase in
  quantity will increase 2 in OCF.

18

• 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.

19

• 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.