FINANCIAL MANAGEMENT
Tools for Project Analysis
PROJECT ANALYSIS
INTRODUCTION TO PROJECT ANALYSIS
 Senior management and the challenge of identifying the set of projects to invest in
 Consistency in the assessment of projects
 Develop plans and budget for capital investments
 Authorize specific projects
 Check whether projects perform as promised
 Do not accept the project’s cash flow forecast at face value
 Uncertain tomorrow: input costs and output prices and hence cashflow
 Project Analysis
 Know the danger signals and the actions that you might take
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Sensitivity Analysis
Scenario Analysis
Break-even Analysis
Monte Carlo Simulation
 Real Options approach to Capital Investments
THE CAPITAL INVESTMENT PROCESS
 Capital Budget
 Preparation of annual capital budget: List of investment projects under consideration by a firm
 Bottom up approach vs Top down approach
 Capital budgeting vs Strategic planning
 Starts with consensus forecast of economic indicators such as inflation, growth in national income
 Project authorization and the problem of biased forecast
 Understatement of project risk: often on account of overconfidence/over-optimism
 Do not add fudge factors to cost of capital
 Postaudit
 Review of project to see if it met forecasts
 Helps management in review of next set of requests for capital investment
TYPES OF ANALYSIS
 Sensitivity Analysis
 Analyzes effects of changes in sales, costs, etc., on project
 Scenario Analysis
 Project analysis, given a particular combination of assumptions
 Simulation Analysis
 Estimates probabilities of different outcomes
 Break Even Analysis
 Level of sales (or other variables) at which the project breaks even
SENSITIVITY ANALYSIS
SENSITIVITY ANALYSIS
 Scenario: As a treasurer of Otobai Company, Osaka, Japan, you are considering
introduction of an electrically powered motor scooter for city use.
Year 0
Investment#
# Values in
billion Japanese Yen
Year 1 – 10
15
Revenue
37.5
Variable Costs
30
Fixed Cost
3
Depreciation
1.5 [15/10]
Pretax profit
3
Tax @ 50%
1.5
Net Profit
1.5
Operating cash flow
3
Net cash flow
-15
3
SENSITIVITY ANALYSIS
 Scenario: As a treasurer of Otobai Company, Osaka, Japan, you are considering
introduction of an electrically powered motor scooter for city use.
 Required: NPV analysis and sensitivity analysis
 Given expected cash-flow forecasts for Otobai Company’s Motor Scooter project,
determine the NPV of project given changes in cash- flow components using 10% cost
of capital. Assume constant variables, except the one you are changing.
INPUTS NEEDED FOR PREPARATION OF INCOME
STATEMENT FOR SCOOTER PROJECT…
INPUTS NEEDED FOR PREPARATION OF INCOME
STATEMENT FOR SCOOTER PROJECT…
 Overall market size of Electrically powered motor scooter
 New proposed product’s market share
 Unit price of each scooter
 Cost structure: variable cost per unit, total fixed cost
 Depreciation rule
 Tax rate
INCOME STATEMENT - PREPARATION
 Unit Sales = New product’s share of market (0.1) x Size of Scooter market (1
million units) = 100,000
 Revenue = Number of units (100,000) x Price per unit (375,000) = 37.5 billion
 Variable cost = Number of units (100,000) x Variable cost per unit (300,000) = 30
billion
NPV CALCULATION
Year 0
Investment#
Year 1 – 10
15
Revenue
37.5
Variable Costs
30
Fixed Cost
3
Depreciation
1.5 [15/10]
Pretax profit
3
Tax @ 50%
1.5
Net Profit
1.5
Operating cash flow
3
Net cash flow
With r = 10%, NPV = +3.43 billion
-15
3
SENSITIVITY ANALYSIS
 Example (Continued)
Outcomes
Variable Pessimistic
Market size
.9 mil
Expected Optimistic
1.0 mil
1.1 mil
Market share
Unit price
Unit var cost
.04
350,000
360,000
.1
375,000
300,000
.16
380,000
275,000
Fixed cost
4 bil
3 bil
2 bil
SENSITIVITY ANALYSIS
 Example (Continued)
 NPV calculations—Optimistic scenario (Market Size)
Year 0
Investment#
NPV = +5.7 billion
Year 1 – 10
15
Revenue
41.25
Variable Costs
33
Fixed Cost
3
Depreciation
1.5
Pretax profit
3.75
Tax @ 50%
1.875
Net Profit
1.875
Operating cash flow
3.375
Net cash flow
-15
3.375
SENSITIVITY ANALYSIS
 Example (Continued)
Possibilities ( Billions ¥)
Variable
Market size
Pessimistic
1.1
Expected Optimistic
3.4
5.7
Market share
Unit price
Unit var cost
- 10.4
- 4.2
- 15.0
3.4
3.4
3.4
17.3
5.0
11.1
Fixed cost
0.4
3.4
6.5
SCENARIO ANALYSIS
SCENARIO ANALYSIS: NPV OF ELECTRIC
SCOOTER
BREAK-EVEN ANALYSIS
NPV SCENARIOS: UNDER DIFFERENT
ANNUAL SALES
BREAK-EVEN CHART
 Point at which NPV=0 is break-even point
 Otobai Motors has a break-even point of 85,000 units sold
PV (Yen)
Billions
400
PV inflows
Break-even
NPV = 0
PV Outflows
200
19.6
85
200
Sales, thousands
ACCOUNTING PROFIT SCENARIOS: UNDER
DIFFERENT ANNUAL SALES
ACCOUNTING BREAK-EVEN
 Accounting break-even does not consider the time value of money
 Otobai Motors has an accounting break-even point of 60,000 units
sold
Revenues
60
Accounting
revenue and
costs (Yen)
Billions
40
Break -even
Profit =0
Costs
20
Sales, thousands
60
200
OPERATING LEVERAGE AND
BREAK-EVEN POINT
ELECTRIC SCOOTER CASH-FLOW
FORECASTS
OPERATING LEVERAGE
 Operating Leverage
 Degree to which costs are fixed
 Degree of Operating Leverage (DOL)
 Percentage change in profits given 1% change in sales
DOL =
% change in profits
% change in sales
or
fixed costs
DOL = 1 +
profits
OPERATING LEVERAGE
 Example
 Using the data from the Otobai scooter project, calculate the DOL
(3 + 1.5)
DOL = 1 +
= 2.5
3
MONTE CARLO SIMULATION
MONTE CARLO SIMULATION
Modeling Process
 Step 1: Model Project
 Step 2: Specify Probabilities
 Step 3: Simulate Cash Flows
 Step 4: Calculate Present Value
SIMULATION OF CASH FLOWS
REAL OPTIONS AND
DECISION TREES
NPV Analysis
REAL OPTIONS AND DECISION TREES
 Decision Trees



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Diagram of sequential decisions and possible outcomes
Help companies analyze options by showing various choices and outcomes
Option to avoid a loss or produce extra profit has value
Ability to create option has value that can be bought or sold
FEDEX’S EXPANSION OPTION: AN
EXAMPLE
FEDEX’S EXPANSION OPTION
Real Options
 Option to expand
 Option to abandon
 Timing option
 Flexible production facilities
DECISION TREE
Phase III Trials and prelaunch, 3 years
Phase II Trials, 2 years
$700 (.80)
- $130
.25
$ 0 (.20)
$ 300 (.80)
- $18
Invest
Yes / No
.44
.56
.50
- $130
$0
$ 0 (.20)
.25
NPV= ?
$ 100 (.80)
- $130
$ 0 (.20)
DECISION TREE
$700 (.80)
- $130
.25
560
$ 0 (.20)
$ 300 (.80)
- $18
Invest
Yes / No
.44
.56
.50
- $130
$0
$ 0 (.20)
.25
NPV= ?
240
$ 100 (.80)
- $130
80
$ 0 (.20)
DECISION TREE
$700 (.80)
- $130
.25
560
$ 0 (.20)
$ 300 (.80)
- $18
Invest
Yes / No
.44
.56
.50
- $130
$0
$ 0 (.20)
.25
NPV= ?
240
$ 100 (.80)
- $130
(700  .80) + (0  .20) = 560
80
$ 0 (.20)
DECISION TREE
NPV = $295
$700 (.80)
- $130
.25
Invest
Yes / No
$ 0 (.20)
560
= 295
3
(1.096)
.44
.50 = −130
- $130
NPV (upside)
+
- $18
.56
$0
$ 300 (.80)
240
$ 0 (.20)
.25
NPV= ?
560
$ 100 (.80)
- $130
80
$ 0 (.20)
DECISION TREE
NPV = $295
$700 (.80)
- $130
.25
560
$ 0 (.20)
$ 300 (.80)
- $18
Invest
Yes / No
.44
.56
.50
- $130
NPV = $52
$0
$ 0 (.20)
.25
NPV= ?
240
$ 100 (.80)
- $130
NPV = - $69
(do not invest, so NPV = 0)
80
$ 0 (.20)
DECISION TREE
NPV = $295
$700 (.80)
- $130
.25
- $18
Invest
Yes / No
$ 300 (.80)
- $130
NPV = $52
$0
240
$ 0 (.20)
(0  .25) + (52  .5) + (295  .25)
$2 100 (.80)
(1.096)
- $130
80
NPV = - $69 = $83
.25
NPV= ?
$ 0 (.20)
NPV = $83
.44
.50
.56
560
NPV =
(do not invest, so NPV = 0)
$ 0 (.20)
DECISION TREE
NPV = $295
$700 (.80)
- $130
.25
- $18
Invest
Yes / No
NPV = $83
.44
.50
.56
$ 0 (.20)
$ 300 (.80)
- $130
NPV = $52
$0
240
$ 0 (.20)
.25
NPV= $19
560
NPV = −18 + (.-44
 83) + (.56  0)
$130
= $19
NPV = - $69
(do not invest, so NPV = 0)
$ 100 (.80)
80
$ 0 (.20)
DECISION TREE
Phase III Trials and prelaunch, 3 years
Phase II Trials, 2 years
NPV = $295
$700 (.80)
- $130
.25
- $18
Invest
Yes / No
NPV = $83
.44
.50
.56
$ 0 (.20)
$ 300 (.80)
- $130
NPV = $52
$0
240
$ 0 (.20)
.25
NPV= $19
560
$ 100 (.80)
- $130
NPV = - $69
(do not invest, so NPV = 0)
80
$ 0 (.20)