Project Evaluation Cash Flow Forecasting

Project Analysis

• Project management involves analysis, planning, teamwork, control, risks, planning, communication, and cost.
• Evaluating projects is challenging due to significant uncertainty in cash flow forecasting
• Few actual projects have positive net present values (+NPV).
• Incentives for managers of projects to be overly optimistic to overinvest.

Forecasting Risk

• Uncertainty about future cash flows can lead to incorrect NPV estimations and poor investment decisions.
• Forecasting risk exists because there are fewer actual projects with positive NPVs.
• Difficulty identifying and removing counterfeit currency is comparable to forecasting risk in project analysis

Organizational Problems

• Inconsistent macro forecasts due to different assumptions among divisional managers about sales growth, inflation, and input costs.
• Establish forecasts for macro variables at the top level and have divisional managers use those forecasts.
• Manager conflicts of interest – motivated to maximize their own future outcomes and might lead to investment in projects with short payback periods.
• Compensation and evaluation should be aligned with long-term metrics like profit rather than short-term metrics like revenue to mitigate this conflict of interest.
• Managers are overly optimistic, hence leading to overinvestment.
• Impose higher hurdle rate for projects

Scenario Analysis

• Analyzing how the project's viability changes when different components of the NPV calculations are changed (due to uncertainty)
• Scenario analysis is vital in stress-testing investment decisions
• Distinguishing between fixed and variable costs is essential if doing project analysis.

Fixed Costs vs. Variable Costs

• Costs related to a project are either fixed or variable..
• Fixed costs do not depend on output level or units sold, whereas variable costs do.

Scenario Analysis in Action

• Firms examine the effects on NPV when key variables (like units sold, price per unit, variable costs, and total fixed costs) change.
• Examples of scenarios with lower and upper bounds (including numbers) are provided, allowing comparison with the base case.

Scenario Analysis in Action- 2

• Base cases, lower bounds, and upper bounds are given for units sales, unit prices, variable costs, and fixed costs for a five-year cash flow project and NPV calculation
• Shows a project cost and life with zero salvage and straight-line depreciated to zero.
• Example numbers are present and solve for the base case using equations including r=12% and tax rate of 21%

Scenario Analysis in Action – 3

• Best and worst-case scenarios based on the lower and upper bounds are included.
• Scenarios and metrics (like net income, cash flow, Net Present Value and IRR) are provided in a table.

Sensitivity Analysis

• Examining the project's NPV by varying a single key variable at a time to understand its impact.
• Managers identify which variables drive the project's success most strongly and need to be forecast accurately to make informed decisions.
• Research may involve surveys and consulting to improve forecasting accuracy

Sensitivity Analysis in Action

• Example of freezing all variables in a base case and changing unit sales from one scenario to another.
• Showing cash flow, Net Present Value, and IRR for various unit sales scenarios.

Simulation Analysis

• A computer runs numerous scenarios, calculating NPV in each, to capture the project's uncertainty.
• Scenario input values are from random distributions defined by the managers and are based on probability occurrences.
• This results in a probability distribution of NPVs (e.g., 93.1% chance of +NPV), which aids in informed decisions. A simulation process is called Monte-Carlo simulation

Break-Even Analysis

• Finding the input value needed for a project to break even.
• Accounting, cash, and financial break-even points are different.
• Accounting break-even: revenues match total costs and net income=0
• Cash break-even: operating cash flow = 0 and operating cash flow = cash inflows=cash outflows
• Financial break even: net present value =0

Accounting Break-Even

• Re-writing revenues as Quantity (Q) x Price (P)
• Decomposing costs into fixed costs (FC) and variable costs (VC)
• Variable Costs= Quantity (Q) x Variable cost per unit (v)
• Net income equation is used to derive Quantity of output for break-even.

Example 9.1 – Accounting Break-Even

• Provides calculations for the accounting break-even quantity (units) using the concept of fixed costs and variable costs relating to the price of each burger.
• Example numbers (cost to produce / price of each burger/overhead costs / depreciation cost) are given for a burger company.
• Calculates break-even number of burgers.

Cash Break-Even

• Using the concept of operating cash flows (OCF) to calculate the quantity for cash break-even.
• Examples are given, including consideration of a tax rate.

Financial Break-Even

• Break-even is determined using the net present value (NPV), operating cash flows (OCF), depreciation (D), annuity factor (A), quantity (Q), price (P), variable cost per unit (v), fixed costs (FC), and the number of years (N) to evaluate the project.

Ex. 9.1 with Financial Break-Even

• Example calculations utilizing a $2M investment over five years (including the depreciation)
• Financial break-even quantity is calculated for a specific discount rate.

Comparing Different Break-Evens

• Showing how cash break-even and accounting break-even quantity values differ.

Operating Leverage

• The degree of project/firm costs that are fixed.
• More fixed costs = Higher operating leverage.
• Degree of operating leverage (DOL): percentage change in EBIT from percentage change in revenues.

Operating Leverage – 2

• Identifying industries with higher relative operating leverage, such as Capital Intensive vs. Labor Intensive, Manufacturing vs. Services based on examples of recognizable brands.

Operating Leverage & Real Investment

• High operating leverage increases difficulty making informed investment decisions.
• Ways to reduce operating leverage are discussed (like subcontracting, using incentive bonuses, and reducing fixed costs)..

Real Options

• Flexibility in a project allows adjustments to future market conditions.
• A range of real options include deferring, abandoning, growing, contracting, shutting down, and switching to other inputs and outputs.

Real Options – 2

• Real options increase project value by adding flexibility in response to uncertain market conditions.
• Real options reduce risk by allowing the firm to adjust behavior during different scenarios.
• Examples (like a project having a cost of $100, and then either GOOD or BAD scenarios where the present value can be $120 or $60) are given. .

Key Terms from This Lecture

• A summary of key project analysis topics and concepts, like Forecasting Risk, Organizational Problems, Economic Moats, Scenario Analysis, Fixed Costs, Variable Costs, Sensitivity Analysis, Simulation Analysis, Break-Even Analysis, Accounting Break-Even, Cash Break-Even, Financial Break-Even, Operating Leverage, Degree of Operating Leverage, and Real Options are included.

This quiz delves into the challenges and concepts of forecasting cash flows for project evaluation. It covers topics such as estimation risk, forecasting risk, economic moats, and the importance of focusing on relevant metrics. Test your understanding of these critical financial concepts.