Project Analysis PDF

Unit 9: Project Analysis Evaluating Projects is Hard! In the last unit, we learned a simple & intuitive methodology for evaluating projects. The NPV Rule! But there are major challenges: A lot of uncertainty in forecasting cash flows Few actual +NPV projects Incentives for managers to be...

Unit 9: Project Analysis Evaluating Projects is Hard! In the last unit, we learned a simple & intuitive methodology for evaluating projects. The NPV Rule! But there are major challenges: A lot of uncertainty in forecasting cash flows Few actual +NPV projects Incentives for managers to be overoptimistic and overinvest 1  Forecasting Risk Since there is uncertainty about future cash flows, there is a possibility that we find the wrong NPV, and then invest in a project which we think is +NPV but which is actually NOT. Forecasting risk (or estimation risk) is the risk that incorrect projections of cash flows lead to wrong investment decisions. Forecasting risk is exacerbated by the fact that there are relatively few actual +NPV projects. (Why few?) Comparable with difficulty of finding/removing counterfeit currency. Later in this unit, we will discuss some ways of minimizing forecasting risk. 2  Organizational Problems Inconsistent macro forecasts Problem: Different divisional managers make different assumptions about sales growth, inflation, input costs, etc. Solution: Establish forecasts for macro variables at the top and have all divisional managers use these figures. Conflicts of interest Problem: Managers are interested in maximizing their own future outcomes. This might lead to overinvestment and investment in projects with short payback periods. Solution: Make sure manager compensation/evaluation is linked to long-term metrics and profits rather than short-term metrics and revenues. 3  Organizational Problems - 2 Overoptimism Problem: From behavioral psychology, we know that humans tend to be overly optimistic, leading to overinvestment. Solution 1: Impose a higher hurdle rate, r, for projects. Caveat: Division managers will often respond by becoming even more overoptimistic about project cash flows to get the same number/fraction of +NPV projects. Solution 2: If you notice that a lot of projects end up underperforming their projections, you can use a higher threshold than Zero-NPV for project approval. 4  Dig Deeper! – Economic Intuition For any supposedly +NPV project, a manager should be able to explain: What is it about this project that makes it +NPV? What competitive advantage is it based on? Why hasn’t someone done it already? Will others be able to copy us if we succeed? Are we able to produce at lower costs than competitors? How? Are there any synergies with existing operations? Is there something proprietary that generates a “moat”? Are there network effects or switching costs? Investing decisions should be based not only on financial calculations, but on economic intuition! 5  Economic Moats ❖ Amazon? Answer: Scale (& Prop. Info?) ❖ Facebook? Answer: Network Effect ❖ Nike? Answer: Brand Loyalty ❖ DeBeers Diamonds? Answer: Locked-up Supply ❖ Pfizer? Answer: Intellectual Property ❖ Comcast? Answer: Regional Oligopoly ❖ Tesla? Answer: Innovation Note: Most of these firms have multiple moats 6 7  Because of uncertainty, there Scenario are many possible scenarios (or possibilities) for what might Analysis occur. Scenario analysis involves changing different components of the NPV calculation and analyzing the effect of those changes on the project’s viability. Scenario analysis is critical to stress-testing investment decisions. When doing project analysis, it’s important to distinguish fixed costs from variable costs. 8  Fixed Costs vs. Variable Costs All costs related to a project can be classified as either fixed costs or variable costs. Fixed costs are costs that do NOT depend on the level of output or units sold, while variable costs are costs that do. What are some fixed costs for Whole Foods? What are some variable costs for Whole Foods? 9  Scenario Analysis in Action - 1 When doing scenario analysis, firms examine what happens to NPV when varying a few key variables that affect cash flows, such as: Units Sold Price per Unit Variable Cost Per Unit Total Fixed Costs Per Year 10  Scenario Analysis in Action - 2 Suppose this project costs $200,000, has a 5-year total life, has no salvage value, and is straight-line depreciated to zero. Also: r = 12% and tax rate is 21%. Let’s work out base case: Sales = Unit Sales × Price Per Unit = 6000 × $80 = $480,000 Var. Costs = Unit Sales × VC Per Unit = 6000 × $60 = $360,000 OCF = (Sales – Costs) × (1 – T) + Depreciation × T = ($480k – $360k – $50k) × 0.79 + $40,000 × 0.21 = $63,700 $63,700 1 NPV = –$200,000 + ( 0.12 ) × (1 – (1.12)5 ) = $29,624 11  Scenario Analysis in Action - 3 We can also create a best-case (optimistic) and a worst-case (pessimistic) scenario, using the lower and upper bounds. This yields the following results: With these results, we can think about the probabilities of the 3 different scenarios and decide on the project. 12  Sensitivity Analysis Sensitivity analysis is similar to scenario analysis but involves varying only ONE key variable (e.g., units sold) at a time to examine its effect on NPV. Allows the manager to see which variable(s) drive most of the uncertainty for the project’s success. Helps manager figure out which variable(s) need to be forecast more precisely, perhaps by doing more research (e.g., consumer surveys, hiring consultants) ❖ Caveat 1: Can only be done with “known unknowns” ❖ Caveat 2: Variables could be correlated with each other so one-at-a-time doesn’t make sense. 13  Sensitivity Analysis in Action Same example as before. Freeze every variable in the “base case” except units sold. 14  Simulation Analysis Simulation analysis involves a computer running thousands (or more) different scenarios and calculating the project’s NPV under each scenario. The computer picks input variable values for each scenario from random distributions specified by the manager, based on probabilities of these values happening. The output is a probability distribution of NPVs allowing statements like: “There is a 93.1% chance of +NPV” This process is also called Monte-Carlo simulation. 15  Break-Even Analysis - 1 Similar to scenario and sensitivity analysis, break- even analysis involves finding the value of a particular input variable that allows the project to just break even. Accounting break-even is the point where net income equals zero, i.e., Revenues = Total Costs Cash break-even is the point where operating cash flows (OCF) equal zero, i.e., Cash Inflows = Cash Outflows Financial break-even is the point where NPV = 0 Note: Accounting or cash break-even is almost always not enough for financial break-even because of opportunity costs! 16  Accounting Break-Even Recall the way we calculate net income: Net Income = (Revenues – Costs – Depreciation) × (1 – T) We can then rewrite Revenues as Quantity (Q) × Price (P) We can also decompose Costs into Fixed Costs (FC) plus Variable Costs (VC), and then variable costs as: Quantity (Q) × Variable cost per unit (v) Plugging these in and then setting net income to zero yields: Net Income = (Q×P – Q×v – FC – D) × (1 – T) = 0 𝐅𝐂+𝐃 Solve algebraically for Accounting Break-Even Q: 𝐏−𝐯 17  Ex. 9.1 – Accounting Break-Even Bob’s Burgers sells burgers for $5 per burger and each burger costs it $3 to produce. Furthermore, it has overhead and other fixed costs of $500,000 and depreciation of $400,000. How many burgers must Bob’s Burgers sell each year to break- even in accounting terms? 𝐅𝐂+𝐃 Answer: 𝐏−𝐯 = ($500,000 + $400,000) / ($5 – $3) = $900,000/$2 = 450,000 burgers per year 18 Example 9.1 continued 19  Cash Break-Even Recall from bottom-up definition of OCF that OCF equals Net Income + Depreciation so setting it to 0: OCF = (Q×P – Q×v – FC – D) × (1 – T) + D = 0 𝐓 𝐅𝐂 − 𝐃 × ( ) 𝟏 −𝐓 Cash Break-Even Q: 𝐏−𝐯 Example 9.1 continued: If Bob’s Burgers has a 21% tax rate, what is its cash break-even? 0.21 = ($500,000 – ($400,000 × ( ))) / ($5 – $3) 0.79 = 196,836 burgers per year Why is this figure lower than the accounting break-even? 20  Financial Break-Even Financial Break-Even depends on the method of depreciation, discount rate, investment and recovery in fixed capital and working capital. We can derive the break-even Q if the: Operating Cash Flows (OCF) are the same for N years Initial investment C is straight-line depreciated over N years so that C = D × N There is no salvage value and no working capital. Let A be the annuity factor multiplying the annual payment to get its Present Value (from Unit 3). 21 Financial Break-Even Formula NPV = PV – Cost must equal zero to break even. NPV = (OCF × A) – (D × N) = 0 N (Q×P – Q×v – FC – D) × (1 – T) + D = D × A N D×( −T) A (Q×P – Q×v – FC) = 1−T 𝐍 𝐃×( −𝐓) FC + 𝐀 𝟏−𝐓 Financial Break-Even Q = 𝐏−𝐯 22  Ex. 9.1 with Financial Break-Even Again Bob’s Burgers, but we also know it’s a $2 mil dollar investment straight-line depreciated over 5 years. Also, project’s discount rate equals 10%. 1 1 A = ( ) × (1 – ) = 3.791 0.1 (1.1)5 𝐍 𝐃×( −𝐓) FC + 𝐀 𝟏−𝐓 Financial Break-Even Q = 𝐏−𝐯 5 $400,000 × ( −0.21) $500,000 + 3.791 0.79 = $2 = 530,756 burgers per year 23 Comparing Different Break-Evens 24  Operating Leverage The operating leverage (OL) of a project (or firm) is the degree to which its costs are fixed. More fixed costs => Higher Operating Leverage It is usually defined using the degree of operating leverage (DOL): DOL = % change in EBIT / % change in revenues Note: Our textbook has a different DOL formula based on CFs: DOL = % change in OCF / % change in units sold Why is Operating Leverage so important? It amplifies the effect of revenues on profits and NPV! It thus makes the project riskier! 25 26  Operating Leverage - 2 Which industries have high operating leverage? Manufacturing vs. Services? Capital Intensive vs. Labor Intensive? Software vs. Hardware? Innovation/R&D vs. Traditional? 27  Operating Leverage & Real Investment High operating leverage makes it more difficult to make correct investment decisions! Why? If a project or asset has high operating leverage, the manager can consider ways to lower it: ❖ Subcontracting ❖ Replace (part of) cash salaries with incentive bonuses ❖ Shorter contracts ❖ Reduce fixed cost expenses such as marketing and R&D ❖ Reduce fixed capital intensity (e.g., “work from home”) 28  Real Options So far, we assumed each project comes with only one switch: ON (do it) or OFF (don’t do it). In reality, financial managers have flexibility to make adjustments related to the project (like a dimmer). Such adjustments related to projects are called real options: ❖ Option to defer the project ❖ Option to abandon the project ❖ Option to expand/grow ❖ Option to contract ❖ Option to shut down and restart ❖ Option to switch use (either of inputs of outputs) 29  Real Options - 2 Real options make a project more valuable by giving the manager flexibility to adjust to future market conditions. They reduce forecasting risk by allowing the firm to optimize its behavior in different, even unexpected, scenarios. Example 9.2: Suppose a project costs $100. There are two possible scenarios (50% chance of each): GOOD and BAD. In GOOD scenario, PV = $120 and in BAD scenario, PV = $60. ❖ If no options: Expected NPV = 0.5 × $20 + 0.5 × –$40 = –$10 ✘ Now, suppose firm has the real option to abandon the project after learning which scenario happened and sell it for $90. In GOOD scenario, it WILL NOT abandon and earn $120, and in BAD scenario, it WILL abandon and sell it for $90. ❖ Then, Expected NPV = 0.5 × $20 + 0.5 × –$10 = $5 > 0 ✓ 30  Key Terms from This Lecture Forecasting Risk Break-Even Analysis Organizational Problems Accounting Break-Even Economic Moats Cash Break-Even Scenario Analysis Financial Break-Even Fixed Costs Operating Leverage Variable Costs Degree of Operating Sensitivity Analysis Leverage Simulation Analysis Real Options 31