Chapter 10Principles of

Corporate FinanceTenth Edition

Slides by

Matthew Will

Project Analysis

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

10-2

Topics Covered

The Capital Investment ProcessSensitivity AnalysisMonte Carlo SimulationReal Options and Decision Trees

10-3

Capital Investments

Items for consideration

Capital Budget – A list of investment projects under consideration by a firm

Do not add fudge factors to the cost of capital

Post audits – A review of the project to see how closely it met forewcasts

10-4

How To Handle Uncertainty

Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project.

Scenario Analysis - Project analysis given a particular combination of assumptions.

Simulation Analysis - Estimation of the probabilities of different possible outcomes.

Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even.

10-5

Sensitivity Analysis

ExampleGiven the expected cash flow forecasts for Otobai Company’s Motor Scooter project, listed on the next slide, determine the NPV of the project given changes in the cash flow components using a 10% cost of capital. Assume that all variables remain constant, except the one you are changing.

10-6

Sensitivity Analysis

Example - continued

315- FlowCashNet

3.0flow cash Operating

1.5after taxProfit

1.550% @ .Taxes

3profitPretax

1.5onDepreciati

3Costs Fixed

30Costs Variable

37.5Sales

15-Investment

10-1 Years0Year

NPV= 3.43 billion Yen

10-7

Sensitivity Analysis

Example - continued

Possible Outcomes

bil 2bil 3bil 4Cost Fixed

275,000300,000360,000CostVar Unit

380,000375,000350,000priceUnit

.16.1.04ShareMarket

mil 1.1mil 1.0mil .9SizeMarket

OptimisticExpectedcPessimistiVariable

Range

10-8

Sensitivity Analysis

Example - continuedNPV Calculations for Optimistic Market Size Scenario

NPV= +5.7 bil yen

3.3815-Flow CashNet

3.38flow cash Operating

1.88taxafter Profit

1.8850% @ .Taxes

3.75profitPretax

1.5onDepreciati

3Costs Fixed

33Costs Variable

41.25Sales

15-Investment

10-1 Years0Year

10-9

Sensitivity Analysis

Example - continued

NPV Possibilities (Billions Yen)

6.53.40.4Cost Fixed

11.13.415.0-CostVar Unit

5.03.44.2-priceUnit

17.33.410.4-ShareMarket

5.73.41.1SizeMarket

OptimisticExpectedcPessimistiVariable

Range

10-10

Electric Scooter – NPV

Cash Flows, Years 1-10, Billions

Base CaseHigh Oil Prices and

Recession Case

1 Revenue 37.5 44.9 2 Variable cost 30.0 35.9 3 Fixed cost 3.0 3.5 4 Depreciation 1.5 1.5 5 Pretax profit (1-2-3-4) 3.0 4.0 6 Tax 1.5 2.0 7 Net profit (5-6) 1.5 2.0 8 Net cash flow (4+7) 3.0 3.5

18.4 21.4 NPV 3.4 6.4

PV of cash flows

10-11

Electric Scooter - Assumptions

Base CaseHigh Oil Prices and

Recession CaseMarket size 1 million .8 million

Market share 0.1 0.13Unit Price 375000 431300

Unit variable cost 300000 345000Fixed cost 3 billion 3.5 billion

Assumptions

10-12

Electric Scooter - Scenarios

InflowsYear 0

Unit Sales, Thousands

Revenue, Years 1-10 Investment

Variable Costs

Fixed Costs Taxes PV Inflows

PV Outflows NPV

0 0 15 0 3 -2.25 0 19.6 -19.6100 37.5 15 30 3 1.5 230.4 227 3.4200 75 15 60 3 5.25 460.8 434.4 26.5

OutflowsYears 1-10

10-13

Electric Scooter – Accounting Profit

Unit Sales, Thousands Revenue

Variable Costs

Fixed Costs Depreciation Taxes

Total Costs

Profit after Tax

0 0 0 3 1.5 -2.25 2.25 -2.25100 37.5 30 3 1.5 1.5 36 1.5200 75 60 3 1.5 5.25 69.75 5.25

10-14

Electric Scooter – Cash Flows

Year 0 Year 1-10

Investment 15.00 1. Revenue 37.50 2. Variable cost 12.00 3. Fixed cost 19.00 4. Depreciation 1.50

5. Pretax profit (1-2-3-4) 5.00 6.Tax 2.50 7. Net profit (5-6) 2.50

8. Operating cash flow (4+7) 4.00

Net cash flow (15.00) 4.00

10-15

Break Even Analysis

Point at which the NPV=0 is the break even point Otobai Motors has a breakeven point of 85,000

units sold.

Sales, 000’s

PV (Yen)

Billions

400

200

19.6

85 200

Break even

NPV=0

PV Inflows

PV Outflows

10-16

Break Even Analysis

Accounting break even is different, yet wrong. It does not consider the time value of money.

Otobai Motors has an accounting breakeven point of 60,000 units sold.

Sales, 000’s

Accounting revenue and costs (Yen)

Billions

60

40

20

60 200

Break even

Profit =0

Revenues

Costs

10-17

Operating Leverage

Operating Leverage- The degree to which costs are fixed.

Degree of Operating Leverage (DOL) - Percentage change in profits given a 1 percent change in sales.

profits

costs fixed1

salesin change %profitsin change %

DOL

or

DOL

10-18

Operating Leverage

Example – Use the data from the Otobai scooter project.What is the DOL?

5.23

1.5)(31=DOL

10-19

Monte Carlo Simulation

Step 1: Modeling the ProjectStep 2: Specifying ProbabilitiesStep 3: Simulate the Cash FlowsStep 4: Calculate Present Value

Modeling Process

10-20

Monte Carlo Simulation

10-21

Flexibility & Real Options

Decision Trees - Diagram of sequential decisions and possible outcomes.

Decision trees help companies determine their Options by showing the various choices and outcomes.

The Option to avoid a loss or produce extra profit has value.

The ability to create an Option thus has value that can be bought or sold.

10-22

Decision Trees

Acquire option on future delivery

Observe growth in demand for airfreight

High Demand

Low Demand

Exercise delivery option

Don’t take delivery

Example - FedEx Expansion Option

10-23

Real Options

1. Option to expand

2. Option to abandon

3. Timing option

4. Flexible production facilities

10-24

Decision Trees$700 (.80)

$ 0 (.20)

$ 300 (.80)

$ 0 (.20)

$ 100 (.80)

$ 0 (.20)

Invest Yes / No

NPV= ?

- $18

- $130

- $130

- $130

.25

.50

.25

$ 0

.44

.56

10-25

Decision Trees$700 (.80)

$ 0 (.20)

$ 300 (.80)

$ 0 (.20)

$ 100 (.80)

$ 0 (.20)

560

240

80

Invest Yes / No

NPV= ?

- $18

- $130

- $130

- $130

.25

.50

.25

$ 0

.44

.56

10-26

Decision Trees$700 (.80)

$ 0 (.20)

$ 300 (.80)

$ 0 (.20)

$ 100 (.80)

$ 0 (.20)

560

240

80

Invest Yes / No

NPV= ?

- $18

- $130

- $130

- $130

.25

.50

.25

$ 0

.44

.56

56020.080.700

10-27

Decision Trees$700 (.80)

$ 0 (.20)

$ 300 (.80)

$ 0 (.20)

$ 100 (.80)

$ 0 (.20)

560

240

80

Invest Yes / No

NPV= ?

- $18

- $130

- $130

- $130

.25

.50

.25

$ 0

.44

.56

295

096.1

560130(upside) NPV 3

NPV = $295

10-28

Decision Trees$700 (.80)

$ 0 (.20)

$ 300 (.80)

$ 0 (.20)

$ 100 (.80)

$ 0 (.20)

560

240

80

Invest Yes / No

NPV= ?

- $18

- $130

- $130

- $130

.25

.50

.25

$ 0

.44

.56

NPV = $295

NPV = $52

NPV = - $69 (do not invest, so NPV = 0)

10-29

Decision Trees$700 (.80)

$ 0 (.20)

$ 300 (.80)

$ 0 (.20)

$ 100 (.80)

$ 0 (.20)

560

240

80

Invest Yes / No

NPV= ?

- $18

- $130

- $130

- $130

.25

.50

.25

$ 0

.44

.56

NPV = $295

NPV = $52

NPV = - $69 (do not invest, so NPV = 0)

83$

096.1

)25.295()5.52()25.0( NPV 2

NPV = $83

10-30

Decision Trees$700 (.80)

$ 0 (.20)

$ 300 (.80)

$ 0 (.20)

$ 100 (.80)

$ 0 (.20)

560

240

80

Invest Yes / No

NPV= $19

- $18

- $130

- $130

- $130

.25

.50

.25

$ 0

.44

.56

NPV = $295

NPV = $52

NPV = - $69 (do not invest, so NPV = 0)

NPV = $83

19$

)056(.)8344(.18 NPV

10-31

Decision Trees$700 (.80)

$ 0 (.20)

$ 300 (.80)

$ 0 (.20)

$ 100 (.80)

$ 0 (.20)

560

240

80

Invest Yes / No

NPV= $19

- $18

- $130

- $130

- $130

.25

.50

.25

$ 0

.44

.56

NPV = $295

NPV = $52

NPV = - $69 (do not invest, so NPV = 0)

NPV = $83

10-32

Web Resources

Click to access web sitesClick to access web sites

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www.jaxworks.com

www.decisioneering.com