Project Analysis Chapter 10 Brealey-Myers-Marcus 6th Edition Business Finance 620 Topics Covered How firms organize the investment process Dealing with “What If” questions Sensitivity Analysis Scenario Analysis Break-even analysis Operating leverage Managerial flexibility and options Capital Budgeting Process Capital Budget The formal roster of planned investment projects Capital Budgeting Process 1 - Identify and rank all investment projects 2 - Authorize projects according to: Government regulation Production efficiency Capacity requirements Net present value (NPV) or other criteria Capital Budgeting Issues Issues to Monitor in Capital Budgeting Ensuring consistent financial forecasts (methodology and assumptions) across a firm’s operating divisions Eliminating conflicts of interest Reducing forecast bias Avoiding costs not properly attributable to a project Using appropriate investment criteria (NPV) And, perhaps most importantly: Managing often openly hostile competition inside a firm among potentially good investment ideas Handling Project Uncertainty Sensitivity Analysis Evaluating the effects of changes in project parameters (such as cost of capital, frontend investments, fixed and variable costs) on project profitability Scenario Analysis Evaluating project performance and profitability under alternative combinations of assumptions. Simulation Analysis Estimating the probability of alternative possible outcomes for an investment project. Break-Even Analysis Determining the level of sales (or some other measure) at which a project (or the entire company) breaks even. Sensitivity Analysis Example The Finefodder supermarket chain plans to open a new superstore. The figures on the following slide represent the most probable future performance of the store over its expected 12-year life. What is the NPV of the new store project? Assume an 8% cost of capital. The most probable future pattern of performance for an investment project is often called the base case. Sensitivity Analysis NPV Calculation for the Superstore Base Case NPV = $478 Sensitivity Analysis The supermarket chain is concerned that assumptions behind the base-case forecast may not prove accurate. Before accepting the project, management decides to examine the effect of certain key assumptions on the project’s overall profitability. Key considerations driving the forecasts include: Sales volume Extent to which costs are fixed Extent to which costs vary with sales The project’s required front-end investment Sensitivity Analysis New Superstore Project Range of Possible Project Outcomes Sensitivity Analysis To investigate the effect of each of the key variables identified by management, the project’s performance forecasts must be subjected to sensitivity analysis. Consider the effect of the project’s initial investment. The range of plausible values runs from $5.0 million (best case) to $6.2 million (worst case). To assess the sensitivity of the project’s profitability to changes in the initial investment, we compute the project’s NPV at both ends of the range of plausible values, holding all other project parameters constant at the base-case level. Sensitivity Analysis NPV Calculation for Pessimistic Initial Investment (note that only the initial investment has been changed) NPV = ($121) Sensitivity Analysis NPV Calculation for Optimistic Initial Investment (note that only the initial investment has been changed) NPV = $778 Sensitivity Analysis NPV for All Four Sets of Sensitivity Analyses (in each case only the variable shown was changed) What do these results seem to be telling us? Sensitivity Analysis Conclusions about the New Superstore Project Whenever a variable is changed in investment project analysis, we should expect a change in the timing and magnitude of the project’s cash flows. Judging from the superstore sensitivity analysis: We seem to be OK with fluctuations in fixed costs. Unless the project’s initial costs get wildly out of hand, we also should be OK there. While the growth of variable costs in relation to sales does warrant further scrutiny, the real culprit appears to be the sales forecast, which has the greatest effect on NPV. Break-Even Analysis There are two forms of break-even analysis: Accounting break-even NPV break-even Accounting break-even occurs at the level of sales at which profit (net income) is zero. You recover your fixed costs (total revenue equals total costs), but you do NOT recover the opportunity cost of the capital tied up in the project. A project that breaks even on an accounting basis almost always will have a negative NPV. Break-Even Example Reconsider the Superstore Project Base Case The project’s break-even sales on an accounting basis total $13.067 million: At accounting break-even, cash flow from operations would be $450,000 a year (the depreciation charge). Break-Even Example With an initial investment of $5.4 million, and annual cash flows of $450,000 for 12 years, there is enough cash in the project to cover the initial investment, but not enough to cover the opportunity cost of capital. At accounting break-even, NPV would be negative: Try discounting the cash flows at a zero-percent cost of capital rather than 8%. What does this tell you? Operating Leverage Operating Leverage The degree to which a project’s (or a firm’s) costs are fixed. Similar to financial leverage (degree to which a firm’s capital structure contains debt). Degree of Operating Leverage (DOL) Percent change in profits for a 1% change in sales. Operating Leverage Example A firm’s sales range from $16 million to $19 million, depending on market conditions. These same conditions generate profits ranging from $550,000 to $1,112,000. What is the DOL? How should this measure be interpreted? Given the firm’s fixed costs, for every 1% change in sales, the firm’s profits can be expected to change by 5.45%. Operating Leverage A firm with high operating leverage (high DOL) has a larger proportion of its costs fixed. Remember – Fixed costs are FIXED!! When economic conditions are improving (and sales are growing), firms with high operating leverage (high DOL) usually perform better. BUT – When economic conditions are careening downhill, a high DOL (large share of fixed costs) becomes a serious drag on financial performance. Managerial Flexibility and Options To date, we have discussed projects as if they have a definite beginning, a middle and an end. We accept a project, and are stuck with it until it’s finally done. HOWEVER – the decision to launch a project rarely is the last decision a project manager makes: There is the option to expand a project down the road. There is the option to abandon (possibly sell) a project. There is the option to restructure a project’s operations. Because these options give project managers greater flexibility in the face of uncertainty, the options add value to a project. Managerial Flexibility and Options Example An auto plant costs $100 million to build. The plant can support production of a line of cars that will generate cash flows with a PV of $140 million, if the plant is successful, but only $50 million, if the plant stumbles. The probability the plant will succeed is 50%. Would you build the plant? Suppose the plant could be sold to another automaker for $90 million, if the auto line is unsuccessful. In this case, would you build the plant? Managerial Flexibility and Options Example Solution The expected NPV of the auto plant is – $5 million. = 0.5 (140 – 100) + 0.5 (50 – 100) In this case, the plant definitely should NOT be built. BUT – Given the “exit option,” the worst-case value of the installed project is now $90 million rather than $50 million. The expected NPV is now $15 million, which makes the plant an acceptable project.