Finance 3310

Lecture 10

Project Analysis and Evaluation

1. General

2. 'What If' Analysis

• Sensitivity analysis
• Scenario analysis

3. Breakeven Analysis

• Accounting Breakeven
• Cash Flow Breakeven
• Financial Breakeven

4. Operating leverage

5. Setting the Bid Price

1. General:

In the capital budgeting analysis to this point we have taken most of the information as given. We should recognize that all capital budgeting problems involve forecasting future cash flows. These cash flows are risky. That is, the actual cash flows may turn out much different than we originally expected. A project that had a positive NPVbased on our forecast cash flows may turn out to have a negative NPV based on actual cash flows. To address the issue of risky cash flows in capital budgeting we resort to 'what if' analysis. We will discuss two types of such analysis: scenario analysis and sensitivity analysis.

Before looking at what-if analysis, one futher comment is in order. We should understand that if a project is estimated to have a positive NPV this implies the project's return exceeds the project's cost of capital. This means the project is making an 'economic' profit. Economic theory predicts that competition will work to eliminate economic profit. Thus we should always try to determine the source of value for the project.

2. What If Analysis:

a. Scenario Analysis - we look at changes in NPV for different sets of values of the variables. These sets of values are called scenarios, and we usually will examine a 'base' case, 'worst' case and 'best' case scenarios. Sometimes it may be necessary to attach probabilities to each of the cases and then compute an 'expected' NPV.

b. Sensitivity analysis - this involves changing a particular variable in the capital budgeting problem, while holding all other variables constant, and examining the effect on NPV. The 'NPV profile' we discussed in the previous chapter is simply the plot of the senstivity of NPV to a change in the cost of capital.

We can plot NPV for changes in each particular variable. The slope of the graph indicates the sensitivity of NPV to a change in a particular variable. We should devote our forecasting effort and resources to those variables which uncertainty has the largest impact on NPV.

3. Breakeven Analysis

a. Accounting Breakeven:

Breakeven analysis is concerned with the relation between sales volume and profitability. How much do we have to sell to break even.

To analyze, we need two concepts:

Fixed costs - those costs which are not affected by or do not vary with sales. Examples include:

• rent
• administrative salaries & expenses
• depreciation
  

Variable (direct) costs - those costs which vary directly with sales. Examples include:

• factory labor
• raw materials
• sales commissions
  

To calculate breakeven, we divide the profit margin on each item into the total amount of fixed costs.

Let P = price, VC = variable cost per unit, FC = total fixed costs, and Q = quantity.

example: suppose: FC = $100,000

P = $1.75

VC = $1.00

Q = ?

Operating profit = Total Revenues - variable costs - fixed costs = P*Q - Q*VC - FC

We want operating profit = 0

==> 0 = P*Q - Q*VC - FC

==> (P - VC)*Q = FC

==> Q = FC/ (P - VC) = FC / profit margin

thus: ==> Q = 100,000 / (1.75 - 1.00) = 133,333 units

b. Cash Flow Breakeven:

Do just like accounting breakeven above, but exclude non-cash expenses such as depreciation from the costs.

c. Financial Breakeven:

This calculates the quantity, Q, which sets NPV equal to zero. If the project involves the same cash flow per year, then it is an annuity and you can do it on your calculator. First calculate the operating cash flow per year needed to create a zero NPV. Then calculate the Q needed to create this cash flow. If the operating cash flows differ by year, you will need a spreadsheet.

4. Operating leverage

Operating leverage - measures the percentage change in operating cash flow for a percentage change in sales. It measures the degree of fixed costs in operations.

Consider two ways in which a company may operate:

(Capital intensive) Higher fixed costs, lower variable ==> higher OL

(Labor intensive) Low fixed, higher variable ==> low OL

Intuition: once you have covered fixed costs, you are contributing more to the bottom line for each unit of sales.

To calculate: %  in OCF / %  in Q

Example of operating leverage:

Consider two companies, A and B:

Now, assume there are two possible outcomes. One outcome involves sales of 500,000 units and the second outcome involves sales of 2,000,000 units.

The degree of operating leverage, DOL, can be measured by:

DOL = 1 + FC/OCF

 

5. Setting the Bid Price

Many times companies are asked to 'bid' on a particular project. That is, they are asked to submit a price at which the company is willing to manufacture or produce a certain project. An example would be a defense contractor submitting a bid to construct a stealth bomber. The question is, how does the company arrive at the correct price to charge?

This is just another capital budgeting problem and a particular example of financial breakeven. We will only propose on a project if we can earn a fair rate of return, or what we have been calling the cost of capital. If we just earn our cost of capital, then the project will have a 0 NPV. Thus the lowest amount of revenues (or price) for which we are willing to do the project is the amount that causes NPV=0. Of course we would like more, but if we set the price too high we will likely lose the bid.

To do this problem, first calculate the present value of all the project cash flows except the revenues (or price). This will usually be a negative number, since it contains cash outflows but does not contain revenues. If the project involves a set of revenues, then determine what annual annuity amount has the same present value. If the project involves a single price, the price (today) should be equal to the present value.

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