FIN 301 Chapter 11 Project Analysis and Evaluation PDF

CHAPTER 11 Project Analysis and Evaluation LEARNING OBJECTIVES After studying this chapter, you should understand: LO1 How to perform and interpret a sensitivity analysis for a proposed investment. LO2 How to perform and interpret a scenario analysis for a proposed investment. LO3 How to d...

CHAPTER 11 Project Analysis and Evaluation LEARNING OBJECTIVES After studying this chapter, you should understand: LO1 How to perform and interpret a sensitivity analysis for a proposed investment. LO2 How to perform and interpret a scenario analysis for a proposed investment. LO3 How to determine and interpret cash, accounting, and financial break-even points. LO4 How the degree of operating leverage can affect the cash flows of a project. LO5 How capital rationing affects the ability of a company to accept projects.  11.1 Evaluating NPV Estimates EVALUATING NPV ESTIMATES Positive NPV: Investment is desirable if its market value > cost. Creates value for the owner. The Challenge: Market value is often not directly observable. Estimates of market value are used instead. Key Question: Are our NPV estimates accurate and close to true values? THE BASIC PROBLEM The Basic Problem in NPV Analysis Initial Steps: Identify relevant cash flows (avoid sunk costs, consider working capital, depreciation, erosion, opportunity costs). Perform Discounted Cash Flow (DCF) analysis. Positive NPV: Good sign but requires further scrutiny.  Key Concerns: True Positive NPV: The project genuinely creates value. Inaccurate Estimate: Positive NPV may result from errors in estimates. Risks of Error: False Positive: Inaccurately concluding NPV is positive. False Negative: Missing valuable opportunities by concluding NPV is negative when it's positive. PROJECTED VERSUS ACTUAL CASH FLOWS Projected Cash Flows: Based on current information, projections represent an estimate of future cash flows (e.g., Year 4 projected cash flow is $700). Uncertainty: The actual cash flow is unlikely to match the projection exactly due to uncertainties and changing conditions over time. Expectation: The projection is an average of all possible future outcomes based on what we know today. Realistic View: We don’t expect projections to be perfect for individual cases, but they should be accurate on average across multiple projects. FORECASTING RISK Forecasting Risk in DCF Analysis Key Inputs: Projected future cash flows are crucial in DCF analysis. GIGO Risk: Inaccurate projections lead to misleading results (Garbage In, Garbage Out). Forecasting Risk: Overly optimistic projections may result in assuming a project has a positive NPV when it does not. Real-World Example: Microsoft’s Xbox One fell short of sales expectations, largely due to pricing misjudgments. Action Plan: Tools are needed to identify potential errors and assess the economic reasonableness of estimates to SOURCES OF VALUE Sources of Value in Investment Decisions Key Question: What makes this investment create positive NPV? Identify Unique Value: Can we manufacture at a lower cost, distribute more effectively, or target an underserved market? Example: Google's Gmail leveraged its search engine and ad delivery technology for value creation. Competition Matters: Highly competitive markets make positive NPV rare; innovations face competitive reactions. Case Study: High LCD TV profits in 2008 dropped as manufacturers increased supply, driving prices down by 2014. 11.2 Scenario and other What-if Analysis GETTING STARTED Investigating Project NPV Under Uncertainty Base Case: Start by estimating NPV based on projected cash flows. Recognizing Error: Acknowledge potential inaccuracies in projections and test different assumptions. Upper and Lower Bounds: Assign realistic ranges (e.g., sales estimates between 90–110 units/year) for uncertain components. Uncertainty Range: While actual values could fall outside these bounds, it’s unlikely the true average will be beyond them. Example: A $200,000 project with a 5-year life and 12% With this information, we can calculate the base- case NPV by first calculating net income: Operating cash flow is thus $30,000 + 40,000 – 10,200 = $59,800 per year. At 12 percent, the five-year annuity factor is 3.6048, so the base-case NPV is: Base-case NPV = - $200,000+59,800 * 3,6048 =$15,567 SCENARIO ANALYSIS Scenario Analysis in NPV Estimation What-If Analysis: Scenario analysis explores how NPV changes when altering key assumptions (e.g., projecting 5,500 vs. 6,000 units sold). Positive Scenarios: If most scenarios show positive NPVs, there's confidence in proceeding with the project. High Risk: A high percentage of negative scenarios indicates forecasting risk and requires further investigation. Worst-Case & Best-Case Scenarios: Worst Case: Assign least favorable values (low sales, high costs) to determine the minimum NPV. Best Case: Assign favorable values for an upper NPV bound. FOR OUR PROJECT, THESE VALUES WOULD BE THE FOLLOWING: With this information, we can calculate the net income and cash flows under each scenario (check these for yourself): Scenario Outcomes: Best vs. Worst Case Worst Case: Positive cash flow of $24,490 but an NPV of −$111,719. A negative return of −14.4%, risking more than half of the initial $200,000 investment. Best Case: Offers an attractive return of 41%. Terminology: Best and worst case scenarios are often misleading; optimistic and pessimistic are more accurate terms. Focus on reasonably likely outcomes rather than extreme, improbable events. Example: BP's Deepwater Horizon disaster illustrates an extreme worst-case scenario, resulting in over $43 billion in costs. HERE IS A TABLE OF THE POSSIBLE OUTCOMES GIVEN BY THE COMPANY: SCENARIO ANALYSIS SUMMARY: ALMADEN'S NPV PROJECTIONS NPV Estimates: Base Case: C$28.7 million Best Case: C$67.9 million No worst-case analysis provided by Almaden; further examination of this scenario is encouraged. Intermediate Scenarios: Consider at least two additional intermediate cases between base and extreme scenarios for a total of five scenarios.  Analysis Limitations: Increasing scenarios may lead to "paralysis of analysis." Scenario analysis shows possibilities but does not dictate project decisions. Real-World Examples of Underestimated Risks: Eurotunnel (Chunnel): Cost overrun from $8.8 billion to $17.9 billion. Actual first-year passengers: 4 million vs. projected 16.8 million. Resulted in $11.1 billion debt negotiations in 2006, but profitability achieved by 2013. Segway: Initially projected 50,000 to 100,000 units sold; only 23,500 sold in three years post-launch. SENSITIVITY ANALYSIS Sensitivity Analysis Overview Definition: Sensitivity analysis investigates how changes in a single variable affect NPV while keeping all other variables constant. Purpose: Identify areas of high forecasting risk by assessing NPV sensitivity to changes in individual components of project cash flow.  Methodology: Start with the base case for all variables except one (e.g., unit sales). Calculate cash flow and NPV using the highest and lowest projections for that variable. Outcome: If NPV is highly sensitive to small changes in a variable, it indicates a high level of forecasting risk associated with that variable. SENSITIVITY ANALYSIS FOR UNIT SALES For comparison, we now freeze everything except fixed costs and repeat the analysis SENSITIVITY ANALYSIS INSIGHTS Key Findings: Estimated NPV is more sensitive to changes in projected unit sales than to changes in fixed costs. Under the worst-case scenario for fixed costs, the NPV remains positive. Graphical Representation: NPV plotted against unit sales shows a straight line; a steeper line indicates greater sensitivity to changes in that variable. Example Case: Bard Ventures' molybdenum mine projections: At $19/ton: NPV = $112 million, IRR = 12.4%. At $30/ton: NPV = $1.152 billion, IRR = 32.0%. Utility of Sensitivity Analysis: Highlights which variables require close monitoring. High sensitivity in difficult-to-forecast variables (e.g., unit sales) indicates high forecasting risk; further market research may be warranted. Limitations: While effective in identifying risk areas, sensitivity analysis does not provide guidance on managing forecasting errors. SIMULATION ANALYSIS Simulation Analysis Overview Definition: Simulation Analysis combines scenario analysis and sensitivity analysis to evaluate multiple variables simultaneously.  Process: Random Selection: Choose random values for all relevant components (e.g., unit sales, price, variable costs) within specified ranges. NPV Calculation: Calculate NPV for each combination. Repetition: Repeat the process thousands of times to generate a range of NPV estimates.  Outcomes: Summarize results to find: Average NPV. Distribution of NPVs (e.g., percentage resulting in negative NPVs). Challenges: 1.Decision Making: No straightforward rules on how to act based on results. 2.Complexity: Requires consideration of interrelationships between cash flow components.  3.Assumptions: Assumes values are equally likely, though values near the base case may be more realistic, complicating probability assignment. Future Potential: With advancements in computer software and hardware, simulation analysis may become more prevalent, especially for large-scale projects.  11.3 Break- Even Analysis BREAK-EVEN ANALYSIS SUMMARY Importance of Sales Volume: Sales volume is often the most challenging variable to forecast accurately when launching new products or entering new markets. Definition: Break-even analysis is a tool that evaluates the relationship between sales volume and profitability. Objective: Determine the sales volume at which a project neither makes a profit nor incurs a loss. Assess the threshold of sales decline before the project starts losing money.  Key Questions: "How low can sales go before we start losing money?" "Is it likely that sales will drop to that level?" Cost Considerations: Break-even analysis involves understanding both fixed costs (unchanging expenses) and variable costs (expenses that fluctuate with sales volume). FIXED AND VARIABLE COSTS Fixed and Variable Costs Summary Importance in Break-Even Analysis: Understanding fixed and variable costs is crucial for analyzing profitability and break-even points. Variable Costs: Definition: Costs that change in direct relation to the quantity of output. Characteristics: Zero when production is zero. Examples include direct labor costs and raw material costs. If operations cease, there are no future costs for labor OUTPUT LEVEL AND VARIABLE COSTS We will assume that variable costs are a constant amount per unit of output. This simply means that total variable cost is equal to the cost per unit multiplied by the number of units. In other words, the relationship between total variable cost (VC), cost per unit of output (v), and total quantity of output (Q) can be written simply as:  For example, suppose variable costs (v) are $2 per unit. If total output (Q) is 1,000 units, what will total variable costs (VC) be? Similarly, if Q is 5,000 units, then VC will be 5,000 × $2 = $10,000. Figure 11.2 illustrates the relationship between output level and variable costs in this case. In Figure 11.2, notice that increasing output by one unit results in variable costs rising by $2, so “the rise over the run”(the slope of the FIXED COSTS Definition: Fixed costs do not change over a specified time period, regardless of the quantity of goods or services produced. Characteristics: Remain constant within a certain production range. Examples include lease payments for facilities and executive salaries. Duration: Fixed costs are not permanent; they apply only during specific periods (e.g., a quarter or a year). Over the long term, all costs can be modified or eliminated. Sunk Cost: Fixed costs are considered sunk costs, as they must be paid regardless of the project's outcome. TOTAL COSTS Total costs (TC) for a given level of output are the sum of variable costs (VC) and fixed costs (FC): So, for example, if we have variable costs of $3 per unit and fixed costs of $8,000 per year, our total cost is: TC = $3 × Q + $8,000 If we produce 6,000 units, our total production cost will be $3 × 6,000 + $8,000 = $26,000. At other production levels, we have the following: ACCOUNTING BREAK-EVEN Definition: The accounting break-even point is the sales level that results in zero project net income. Calculation Overview: To find the accounting break-even, consider the following: Selling Price: Price at which the product is sold. Cost Price: Price at which the product is purchased. Fixed Costs: Total fixed expenses (e.g., rent, salaries). Depreciation: Non-cash expense related to Example Scenario: Selling price of computer disks: $5 per disk. Cost price of disks: $3 per disk. Fixed costs: $600. Depreciation: $300. Objective: Calculate the number of disks needed to be sold to achieve zero net income. OUTPUT LEVEL AND TOTAL COSTS For every disk we sell, we pick up $5 − 3 = $2 toward covering our other expenses (this $2 difference between the selling price and the variable cost is often called the contribution margin per unit). We have to cover a total of $600 + 300 = $900 in accounting expenses, so we obviously need to sell $900/2 = 450 disks. We can check this by noting that at a sales level of 450 units, our revenues are $5 × 450 = $2,250 and our variable costs are $3 × 450 = $1,350. Income statement: Key Points:  Interest expenses are not included in calculating net income or cash flow for a proposed project.  Depreciation is included in expenses, even though it is a non-cash outflow. This leads to the term accounting break-even.  When net income equals zero, pretax income and taxes are also zero. Thus, revenues equal costs with no profit to tax.  Graphical Representation: ACCOUNTING Revenue Line: Starts at zero when BREAK-EVEN output is zero and increases by $5 for each unit sold (slope of the revenue line = 5). Total Costs Line: Represents the cumulative costs, including fixed and variable costs. Break-Even Point: The break-even point occurs when total revenues equal total costs. In this example, the break-even output is at 450 units, where the revenue and total costs lines intersect. Conclusion: Below 450 units, the accounting profit is negative; at 450 units, it is zero, indicating the point  ACCOUNTING BREAK-EVEN: A CLOSER LOOK In our numerical example, notice that the break-even level is equal to the sum of fixed costs and depreciation, divided by price per unit less variable costs per unit. This is always true. To see why, we recall all of the following variables: USES FOR THE ACCOUNTING BREAK-EVEN Importance of Accounting Break-Even: Sales Volume Focus: For businesses like a specialty ice cream manufacturer expanding into new markets, understanding the accounting break-even point helps assess sales volume risks, which is often the most uncertain factor. Market Share Insight: If the break-even analysis shows a need for 30% market share but current sales are only 10%, the forecast's reliability is questioned, indicating potential negative NPV. Firm Commitments: If firm commitments meet or exceed the break-even amount, the forecasting risk diminishes, leading to greater confidence in projections. Additional Benefits: Ease of Calculation: Similar to payback period, accounting break-even is straightforward to calculate and communicate. Impact on Total Earnings: Projects that fail to break even negatively affect total accounting earnings. Opportunity Cost Consideration: A project that just breaks even might not yield returns exceeding those available from alternative investments, highlighting its financial drawbacks. This analysis helps businesses make informed decisions about project viability and market strategies.  11.4 Operating Cash Flows, Sales Volume, and OPERATING CASH FLOW, SALES VOLUME, AND BREAK- EVEN Focus on Cash Flow: While accounting break- even is a useful tool for project analysis, the primary interest lies in understanding cash flow rather than accounting income. Sales Volume as a Critical Variable: To assess project viability effectively, it's essential to explore the relationship between sales volume and cash flow beyond just determining the accounting break-even point.  Goal of Analysis: This section aims to illustrate how operating cash flow relates to sales volume and introduce additional break-even measures, simplifying the discussion by excluding tax effects. Relationship Between Accounting Break-Even and Cash Flow: Understanding this relationship helps provide a clearer picture of how sales volume impacts overall project cash flow.  ACCOUNTING BREAK-EVEN AND CASH FLOW Cash Flow Analysis for Wettway Sailboat Corporation Project Overview: Wettway Sailboat Corporation is considering launching the new Margo-class sailboat. Selling Price: $40,000 per boat Variable Costs: $20,000 per boat (50% of selling price) Fixed Costs: $500,000 per year  Investment Details: Total Investment: $3,500,000 Depreciation: Straight-line to zero over five years Salvage Value: $0 Working Capital: None required Required Return: 20% on new projects Sales Projections: Total Sales Over Five Years: 425 boats (approximately 85 boats per year) Decision Point: To determine if the project should be launched, the cash flow implications based on sales volume and the accounting break-even need to be evaluated. EXAMPLE….OPERATING CASH FLOW AT 85 BOATS PER YEAR IS: CALCULATING THE BREAK- EVEN LEVEL Break-Even Analysis for Wettway Sailboat Corporation 1.Key Questions: 1.How many boats need to be sold for accounting break- even? 2.What will be the annual cash flow from the project at break-even? 3.What will be the return on investment (ROI) in this case? 1.Financial Overview: 1.Selling Price per Boat: $40,000 2.Variable Cost per Boat: $20,000 3.Contribution Margin per Boat: $40,000 - $20,000 = $20,000 2.Cost Structure: 1.Depreciation: Total Investment ($3,500,000) / 5 years = $700,000/year 2.Total Fixed Costs (including Depreciation): $500,000 (fixed costs) + $700,000 (depreciation) = $1,200,000/year CALCULATING BREAK EVEN Consider this example; Before fixed costs and depreciation are considered, Wettway generates $40,000 – 20,000 = $20,000 per boat (this is revenue less variable cost). Depreciation is $3,500,000/5 = $700,000 per year. Fixed costs and depreciation together total $1.2 million, so Wettway needs to sell (FC + D)/(P – v) = $1.2 million/20,000 = 60 boats per year to break even on an accounting basis. This is 25 boats less than projected sales; so, assuming that Wettway is confident its projection is accurate to within, say, 15 boats, it appears unlikely that the new investment will fail to at least break even on an accounting basis. To calculate Wettway’s cash flow in this case, we note that if 60 boats are sold, net income will be exactly zero. Recalling from the previous chapter that operating cash flow for a project can be written as net income plus depreciation (the bottom-up definition), we can see that the operating cash flow is equal to the depreciation, or $700,000 in this case. The internal rate of return is exactly zero (why?). Payback and Break-Even As our example illustrates, whenever a project breaks even on an accounting basis, the cash flow for that period will equal the depreciation. This result makes perfect accounting sense. For  The depreciation is straight-line to a zero salvage, or $20,000 per year. If the project exactly breaks even every period, then the cash flow will be $20,000 per period.  The sum of the cash flows for the life of this project is 5 × $20,000 = $100,000, the original investment. What this shows is that a project’s payback period is exactly equal to its life if the project breaks even every period.  Similarly, a project that does better than break even has a payback that is shorter than the life of PAYBACK AND BREAK-EVEN Key Relationship: When a project breaks even on an accounting basis, its cash flow for that period equals its depreciation. Illustrative Example: Investment: $100,000 in a five-year project. Depreciation: Straight-line to zero, equating to $20,000 per year. Cash Flow at Break-Even: If the project breaks even each period, cash flow = $20,000.  Cash Flow Summation: Total cash flows over 5 years: 5×20,000=100,0005 \ times 20,000 = 100,0005×20,000=100,000, which equals the original investment. This indicates that the payback period is equal to the project's life if it breaks even every period. Implications: If a project performs better than break-even, the payback period is shorter than its life, yielding a positive rate of return. Conversely, a project that breaks even on an accounting basis results in: Negative Net Present Value (NPV) Zero return on investment. SALES VOLUME AND OPERATING At this point, we can CASH FLOW generalize our example and introduce some other breakeven measures.  From our discussion in the previous section, we know that, ignoring taxes, a project’s operating cash flow, OCF, can be written simply as EBIT plus depreciation: CASH FLOW, ACCOUNTING, AND FINANCIAL BREAKEVEN POINTS OPERATING CASH FLOW AND SALES VOLUME This tells us what sales volume (Q) is necessary to achieve any given OCF, so this result is more general than the accounting ACCOUNTING BREAK-EVEN REVISITED Looking at Figure 11.5, suppose operating cash flow is equal to depreciation (D). Recall that this situation corresponds to our break-even point on an accounting basis. To find the sales volume, we substitute the $700 depreciation amount for OCF in our general expression:  CASH BREAK-EVEN Cash Break-Even We have seen that a project that breaks even on an accounting basis has a net income of zero, but it still has a positive cash flow. At some sales level below the accounting break-even, the operating cash flow actually goes negative. This is a particularly unpleasant occurrence. If it happens, we actually have to supply additional cash to the project just to keep it afloat. To calculate the cash break-even (the point where operating cash flow is equal to zero), we put in a zero for OCF  CASH BREAK-EVEN The sales level that results in a zero operating cash flow. Wettway must therefore sell 25 boats to cover the $500 in fixed costs. Notice that a project that just breaks even on a cash flow basis can cover its own fixed operating costs, but that is all. It never pays back anything, so the original investment is a complete loss (the IRR is –100 percent). FINANCIAL BREAK-EVEN Definition: Financial Break-Even: The sales level that results in a zero Net Present Value (NPV). It reflects the sales volume required to cover all costs, including the opportunity cost of capital. Importance: Financial managers focus on this measure to ensure that a project's cash flows cover the initial investment when considering the required rate of return. Example: Wettway Sailboat Project: Initial Investment: $3,500,000. Required Return: 20% per year. Project Life: 5 years. Calculation Method: To determine the financial break-even point, the present value of the operating cash flows must equal the initial investment. As cash flow is consistent each year, the scenario can be treated as an ordinary annuity. Annuity Factor: At a 20% rate, the 5-year annuity factor is 2.9906. Next Steps: Calculate the operating cash flow (OCF) required to achieve zero NPV by equating the present value of cash  11.4 Operating Leverage  THE BASIC IDEA Definition: Operating leverage measures the extent to which a firm or project relies on fixed production costs. Characteristics: Low Operating Leverage: Firms with lower fixed costs, leading to more flexibility during changes in sales volume. High Operating Leverage: Firms with high fixed costs, typically found in capital-intensive projects that require significant investment in plant and equipment.  Example - Wettway Corporation: Production Options: Wettway can either invest in equipment to produce sailboat components in-house (high operating leverage) or outsource some production (lower operating leverage). The choice impacts fixed costs, depreciation, and the overall risk profile of the project. Understanding operating leverage is crucial for evaluating the financial risk and potential profitability of new ventures. IMPLICATIONS OF OPERATING LEVERAGE Operating Leverage Effect: Fixed costs function as a lever, causing small percentage changes in operating revenue to result in larger percentage changes in operating cash flow and NPV. Forecasting Risk: A higher degree of operating leverage increases potential risks, as small errors in sales volume forecasts can lead to significant discrepancies in cash flow projections. Managerial Strategy: To manage uncertainty, it is advisable to minimize operating leverage. Lower operating leverage typically results in a lower break-even point, reducing the financial risk associated with forecasting errors. Understanding these implications helps in making informed decisions about project structures and financial planning. MEASURING OPERATING LEVERAGE Definition of Degree of Operating Leverage (DOL): DOL measures the percentage change in operating cash flow (OCF) relative to the percentage change in quantity sold. Formula: The relationship can be expressed as: Percentage change in OCF=DOL×Percentage chang e in QPercentage change in OCF=DOL×Percentage change in Q Interpretation: A higher DOL indicates that a small increase in sales volume leads to a larger increase in operating cash flow, reflecting a greater commitment to fixed costs. This measure helps evaluate the sensitivity of a project’s profitability to changes in sales volume. The ratio FC/OCF simply measures fixed costs as a percentage of total operating cash flow. Notice that zero fixed costs would result in a DOL of 1, implying that percentage changes in quantity sold would show up one for one in operating cash flow. In other words, no magnification, or leverage, effect would exist. To illustrate this measure of operating leverage, we go back to the Wettway sailboat project. Fixed costs were $500 and (P − v) was $20, so OCF was: OCF = –$500 + 20 × Q Suppose Q is currently 50 boats. At this level of output, OCF is –$500 + 1,000 = $500. If Q rises by 1 unit to 51, then the percentage change in Q is (51 – 50)/50 =.02, or 2%. OCF rises to $520, a change of P – v = $20. The percentage change in OCF is ($520 – 500)/500 =.04, or 4%. So a 2 percent increase in the number of boats sold leads to a 4 percent increase in operating cash flow. The degree of operating leverage must be exactly 2.00. We can check this by noting that: This verifies our previous calculations. Our formulation of DOL depends on the current output level, Q. However, it can handle changes from the current level of any size, not just one unit. For example, suppose Q rises from 50 to 75, a 50 percent increase. With DOL equal to 2, operating cash flow should increase by 100 percent, or exactly double. Does it? The answer is yes, because, at a Q of 75, OCF is: OCF = –$500 + 20 × 75 = $1,000 Notice that operating leverage declines as output (Q) rises. For example, at an output level of 75, we have: OPERATING LEVERAGE AND BREAK-EVEN We illustrate why operating leverage is an important consideration by examining the Wettway sailboat project under an alternative scenario. At a Q of 85 boats, the degree of operating leverage for the sailboat project under the original scenario is; 11.6 Capital Rationing CAPITAL RATIONING Definition: Capital rationing occurs when a firm has profitable projects with positive NPVs but lacks the necessary funding to pursue them. Example Scenario: Division managers identify $5 million worth of excellent projects but can only allocate $2 million for investment. Challenge: This situation presents a dilemma, as there may be no straightforward solution to prioritize or fund the available projects effectively.  SOFT RATIONING Definition: Soft rationing occurs when different units within a business are allocated a fixed amount of money each year for capital spending. This approach helps manage and track overall spending. Key Point: The corporation is not actually short on capital; additional funds can be raised if management decides to do so. Initial Steps: When facing soft rationing, the first step is to seek a larger budget allocation. If that’s not possible, prioritize projects with the highest net present value (NPV) within the existing budget. Consideration for Chronic Issues: If soft rationing persists over time, it may indicate a deeper problem, as this means positive NPV investments are continually overlooked. This undermines the firm's goal of maximizing value, creating ambiguity in project selection