T11.1 Chapter Outline
Chapter 11
Project Analysis and Evaluation
Chapter Organization
 11.1 Evaluating NPV Estimates
 11.2 Scenario and Other “What-if” Analyses
 11.3 Break-Even Analysis
 11.4 Operating Cash Flow, Sales Volume, and Break-Even
 11.5 Operating Leverage
 11.6 Additional Considerations in Capital Budgeting
 11.7 Summary and Conclusions
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Finance 3040
T11.2 Evaluating NPV Estimates
I: The Basic Problem
 The basic problem: How reliable is our NPV estimate?

Projected vs. Actual cash flows
Estimated cash flows are based on a distribution of possible
outcomes each period

Forecasting risk
The possibility of a bad decision due to errors in cash flow
projections - the GIGO phenomenon

Sources of value
What conditions must exist to create the estimated NPV?

“What If” analysis:
A.
Scenario analysis
B.
Sensitivity analysis
U of L Finance 3040
Slide 2
T11.3 Evaluating NPV Estimates
II: Scenario and Other “What-If” Analyses
 Scenario and Other “What-If” Analyses

“Base case” estimation
Estimated NPV based on initial cash flow projections

Scenario analysis
Position best- and worst-case scenarios and calculate NPVs

Sensitivity analysis
How does the estimated NPV change when one of the input
variables changes?

Simulation analysis
Vary several input variables simultaneously, then construct a
distribution of possible NPV estimates
U of L Finance 3040
Slide 3
NPV - Incremental Well Case
CAPEX
Year
2002
Net of Royalties
at 20%
Fixed Well
Costs
Variable
Costs
Total Well
Costs
Net Cash
Flow
434940
324220
267000
224280
192240
160200
145340
125730
105120
95440
85260
74580
63400
52720
52720
347952
259376
213600
179424
153792
128160
116272
100584
84096
76352
68208
59664
50720
42176
42176
30000
30000
30000
31000
31500
32000
32000
32500
33000
33500
34000
34500
35500
36000
36500
52500
48000
38000
30000
24000
18500
14500
10000
7500
5000
3000
3000
3000
3000
3000
82500
78000
68000
61000
55500
50500
46500
42500
40500
38500
37000
37500
38500
39000
39500
-300,000
265452
181376
145600
118424
98292
77660
69772
58084
43596
37852
31208
22164
12220
3176
2676
2403190
1922552
-300,000
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Total
Incremental Price
WI @50%WI Revenues
Production$Cdn/bbl
$
m bbls
m bbls
33
29
25
21
18
15
13
11
9
8
7
6
5
4
4
-300,000
26.36
22.36
21.36
21.36
21.36
21.36
22.36
22.86
23.36
23.86
24.36
24.86
25.36
26.36
26.36
208
16.5
14.5
12.5
10.5
9
7.5
6.5
5.5
4.5
4
3.5
3
2.5
2
2
104
492000
NPV at 15%
NPV at 10%
U of L Finance 3040
Slide 4
263000
$394,442.02
$505,363.01
755000
116755
T11.4 Fairways Driving Range Example
 Fairways Driving Range expects rentals to be 20,000 buckets at $3 per
bucket. Equipment costs $20,000 and will be depreciated using SL over 5
years and have a $0 salvage value. Variable costs are 10% of rentals and
fixed costs are $40,000 per year. Assume no increase in working capital nor
any additional capital outlays. The required return is 15% and the tax rate is
15%.
Revenues
$60,000
Variable costs
6,000
Fixed costs
40,000
Depreciation
4,000
EBIT
$10,000
Taxes (@15%)
1500
Net income
U of L Finance 3040
$ 8,500
Slide 5
T11.4 Fairways Driving Range Example (concluded)
 Estimated annual cash inflows:
$10,000 + 4,000 - 1,500 = $12,500
net income plus dep’n - taxes
 At 15%, the 5-year annuity factor is 3.352. Thus, the base-case
NPV is:
NPV = $-20,000 + ($12,500 3.352) = $21,900.
U of L Finance 3040
Slide 6
T11.5 Fairways Driving Range Scenario Analysis
INPUTS FOR SCENARIO ANALYSIS
 Base case: Rentals are 20,000 buckets, variable costs
are 10% of revenues, fixed costs are $40,000,
depreciation is $4,000 per year, and the tax rate
is 15%.
 Best case: Rentals are 25,000 buckets, variable costs are
8% of revenues, fixed costs are $40,000,
depreciation is $4,000 per year, and the tax
rate is 15%.
 Worst case: Rentals are 18,000 buckets, variable costs are
12% of revenues, fixed costs are $40,000,
depreciation is $4,000 per year, and the tax
rate is 15%.
U of L Finance 3040
Slide 7
T11.5 Fairways Driving Range Scenario Analysis (concluded)
Revenues
Net
Income
Project
Cash Flow
NPV
$21,250
$25,250
$64,635
Scenario
Rentals
Best Case
25,000
$75,000
Base Case
20,000
60,000
8,500
12,500
21,900
Worst Case
18,000
54,000
2,992
6,992
3,437
U of L Finance 3040
Slide 8
T11.6 Fairways Driving Range Sensitivity Analysis
INPUTS FOR SENSITIVITY ANALYSIS
 Base case: Rentals are 20,000 buckets, variable costs
are 10% of revenues, fixed costs are $40,000,
depreciation is $4,000 per year, and the tax
rate is 15%.
 Best case: Rentals are 25,000 buckets and revenues are
$75,000. All other variables are unchanged.
 Worst case: Rentals are 18,000 buckets and revenues are
$54,000. All other variables are unchanged.
U of L Finance 3040
Slide 9
T11.6 Fairways Driving Range Sensitivity Analysis (concluded)
Net
Sensitivity
Rentals
Revenues
Best case
25,000
$75,000
Base case
20,000
Worst case
18,000
cash flow
NPV
$19,975
$23,975
$60,364
60,000
8,500
12,500
21,900
54,000
3,910
7,910
6,514
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income
Project
Slide 10
T11.7 Fairways Driving Range: Rentals vs. NPV
Fairways Scenario Analysis - Rentals vs. NPV
NPV
Best case
$60,000
NPV = $64,635
x
Base case
NPV = $21,900
x
Worst case
0
NPV = $3,437
x
-$60,000
15,000
20,000
Rentals per Year
U of L Finance 3040
Slide 11
25,000
Break - Even Analysis
 Where the crucial variable for a project and its success is sales volume
- various forms of break-even analysis can be developed essentially
addressing the question of ‘how bad can sales get before we start
losing money’





an understanding of the fixed and variable costs associated with the project
is important in developing the break-even analysis.
Variable Costs - ‘costs that change when the quantity of output changes.’
Variable cost VC = total quantity (Q) * cost per unit (v)
Fixed Costs - ‘costs that do not change when the quantity of output changes
during a particular time period’
• fixed costs are not fixed forever - only for a prescribed period of time; in
the long run all costs are variable
Total Costs TC for a given level of output is the sum of the Variable costs VC
and fixed costs FC
TC = VC+FC or v*Q + FC
Marginal or incremental cost is the change in costs that occurs when there is
a small change in output - what happens to our costs when we produce one
more unit
U of L Finance 3040
Slide 12
Accounting Break-Even
 Accounting break-even is the sales level that results in zero
project net income







P = Selling Price per unit
v = Variable cost per unit
Q = total units sold
FC = Fixed Costs
D = Depreciation
t = Tax rate
VC = Variable cost in dollars
Accounting break-even;
Q =(FC+D)/(P-v)
U of L Finance 3040
Slide 13
T11.10 Fairways Driving Range: Accounting Break-Even Quantity
 Fairways Accounting Break-Even Quantity (Q)
Q = (Fixed costs + Depreciation)/(Price per unit - Variable cost per unit)
= (FC + D)/(P - V)
= ($40,000 + 4,000)/($3.00 - .30)
= 16,296 buckets
If sales do not reach 16,296 buckets, the firm will incur losses in an accounting
sense.
U of L Finance 3040
Slide 14
Operating Cash Flow, Sales Volume and Break-Even
 Given our focus on cash flow, the next evolution in break-
even analysis is to look at the relationship between
operating cash flow and sales volume
 Cash break-even - the point where operating cash flow (OCF)
is zero (but the project NPV will be negative)

OCF = (P-v) *Q - FC or Q = (FC + OCF)/(P-v)
Cash break-even then is where OCF = 0

Q = (FC + 0)/(P-v)

$40,000/2.70 =‘s 14,815 buckets

U of L Finance 3040
Slide 15
Financial Break-Even
 The point where the sales level results in a zero NPV
 the first step is determining OCF for the NPV to be zero
 a zero NPV occurs when the PV of the OCF equals the original
investment - if the cash flow is the same each year we can use the
annuity formula to solve for OCF
• original investment or PV = OCF * annuity future value factor
• OCF = original investment/Annuity future value factor
• OCF=(P-v)*Q-FC or Q = (FC +OCF)/(P-v)
 the financial break-even is often greater than the accounting
break-even or conversely when a project just breaks even in an
accounting sense it will usually be losing money in a financial or
economic sense
 …..calculate financial B/E for the Fairways example
U of L Finance 3040
Slide 16
Break-Even Example
Assume you have the following information about Vanover
Manufacturing:
 Price = $5 per unit; variable costs = $3 per unit
 Fixed operating costs = $10,000
 Initial cost is $20,000
 5 year life; straight-line depreciation to 0, no salvage value
 Assume no taxes
 Required return = 20%
U of L Finance 3040
Slide 17
Break-Even Example
A. Accounting Break-Even
Q = (FC + D)/(P - V) = ($10,000 + $4,000)/($5 - 3) = 7,000
units
IRR =
0
; NPV = -$8,038
B. Cash Break-Even
Q = FC + 0)/(P - V) = $10,000/($5 - 3) = 5,000 units
IRR = -100% ; NPV = -$20,000
C.. Financial Break-Even
Q = (FC + $6,688)/(P - V)
= ($10,000 + 6,688)/($5 - 3) = 8,344 units
IRR = 20% ; NPV = 0
U of L Finance 3040
Slide 18
T11.12 Summary of Break-Even Measures (Table 11.1)
I.
The General Expression
Q = (FC + OCF)/(P - V)
where:
FC = total fixed costs
P = Price per unit
v = variable cost per unit
II. The Accounting Break-Even Point
Q = (FC + D)/(P - V)
At the Accounting BEP, net income = 0, NPV is negative, and IRR of 0.
III. The Cash Break-Even Point
Q = FC/(P - V)
At the Cash BEP, operating cash flow = 0, NPV is negative, and IRR = -100%.
IV. The Financial Break-Even Point
Q = (FC + OCF*)/(P - V)
At the Financial BEP, NPV = 0 and IRR = required return.
U of L Finance 3040
Slide 19
Operating Leverage
 Operating leverage is ‘ the degree to which a firm or project
relies on fixed costs’ - what is the relationship between fixed
and variable costs for the firm or project.



Low operating leverage means low fixed costs as a proportion of
total costs
High operating leverage reflects high fixed costs - often high
investment in plant and equipment OR in the ‘new economy high
investment in research and development to develop software for
example.
Once a break-even point is reached, firms or projects with high
operating leverage generate higher cash flow/earnings or NPV for
each additional unit sold vs firms with low operating leverage conversely lower sales volume can magnify cash flow/earnings or
NPV in the other direction!
U of L Finance 3040
Slide 20
Implications of Operating Leverage


Once fixed costs are recovered, it only takes a small % change in
revenues to result in a significant % change in OCF and NPV
The higher the degree of operating leverage the greater the impact
from forecasting risk – ie the risk of missing your volume
projections
• If your project is ‘risky’ to begin with, you are adding to the risk
of the project if your firm has a high degree of operating
leverage
• A risk management approach then would be to bring down the
operating leverage associated with higher risk projects so that
the break even point is minimized
• Outsourcing some costs can turn them from a fixed cost to a
partial variable cost (part of the driver behind the outsourcing
phenomena)
U of L Finance 3040
Slide 21
Operating Leverage continued
 The degree of operating leverage (DOL) is ‘the percentage
change in operating cash flow relative to the percentage
change in quantity sold’


% change in OCF = DOL * % change in Q
DOL = 1+ FC/OCF
 The issue of sub-contracting out certain functions is often a
question of operating leverage - sub-contracting has the effect
of reducing the DOL as more costs become variable and fixed
costs are reduced
 Firms operating in the ‘new economy’ e.g. High tech firms can
have a high DOL as much of the their investment in research
and development is a fixed cost that does not vary with sales
volumes - thus the higher degree of leverage to sales volumes
U of L Finance 3040
Slide 22
Fairways Driving Range DOL
 Since % in OCF = DOL  %  in Q, DOL is a “multiplier” which
measures the effect of a change in quantity sold on OCF.
 For Fairways, let Q = 20,000 buckets. Ignoring taxes,
OCF = $14,000 and fixed costs = $40,000, and
Fairway’s DOL = 1 + FC/OCF = 1 + $40,000/$14,000 = 3.857.
In other words, a 10% increase (decrease) in quantity sold will result in
a 38.57% increase (decrease) in OCF.
 Two points should be kept in mind:
Higher DOL suggests greater volatility (i.e., risk) in OCF;
Leverage is a two-edged sword - sales decreases will be magnified as
much as increases.
U of L Finance 3040
Slide 23
Managerial Options and Capital Budgeting
 Managerial options and capital budgeting

What is ignored in a static DCF analysis?
Management’s ability to modify the project as events occur.


Contingency planning
1.
The option to expand
2.
The option to abandon
3.
The option to wait
Strategic options
1.
“Toehold” investments
2.
Research and development
U of L Finance 3040
Slide 24
Capital Rationing
 Capital rationing

Definition: The situation in which the firm has more good
projects than money.
Soft rationing - limits on capital investment funds set within the
firm.
Hard rationing - limits on capital investment funds set
outside of the firm (i.e., in the capital markets).
…firm is in financial distress, external capital essentially becomes
unavailable

What would be the opposite of capital rationing – more
money than good projects – what then?
………firms start buying back shares
U of L Finance 3040
Slide 25
DOL Example
 A proposed project has fixed costs of $20,000 per year. OCF at
7,000 units is $55,000. Ignoring taxes, what is the degree of
operating leverage (DOL)?
 If units sold rises from 7,000 to 7,300, what will be the increase
in OCF? What is the new DOL?
DOL = 1 + ($20,000/$55,000) = 1.3637
%  Q = (7,300 - 7,000)/7,000 = 4.29%
and
%  OCF = DOL(%  Q) = 1.3637 (4.29) = 5.85%
New OCF = ($55,000)(1.0585) = $58,218
DOL at 7,300 units = 1 + ($20,000/$58,218) = 1.3435
U of L Finance 3040
Slide 26