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McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Presentation on theme: "McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved."— Presentation transcript:

1 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2 10-2 Project Analysis Chapters 8 and 9 develop a framework for project analysis. This chapter analyzes the robustness of a projects value by asking some What If Questions.

3 10-3 Capital Budget Capital Budget – A list of planned investment projects.

4 10-4 Capital Budgeting: The Decision Process 1.Stage 1: The Capital Budget 2.Stage 2: Project Authorization Outlays required by law or company policy Maintenance or cost reduction Capacity expansion in existing business Investment for new products

5 10-5 Potential Capital Budgeting Problems Ensuring forecasts are consistent Eliminating conflicts of interest Reducing forecast bias Proper selection criteria (NPV and others)

6 10-6 What-if Testing Sensitivity Analysis - Analysis of the effects on project profitability of changes in sales, costs, etc. Scenario Analysis – Analysis given a particular combination of assumptions. Simulation Analysis - Estimation of the probabilities of different possible outcomes. Break-Even Analysis - Analysis of the level of sales at which the company breaks even.

7 10-7 Sensitivity Analysis Analysis of the effects on project profitability of changes in sales, costs, etc. Why is sensitivity analysis useful?

8 10-8 Sensitivity Analysis - Example Base Case: Expected cash flows from a new project (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s) NPV = $1,382.47 IRR = 12.7% Payback Period = 6 years Profitability Index =.256 NPV = IRR = Payback Period = Profitability Index = Calculate:

9 10-9 Sensitivity Analysis - Example Possible Range of Variables

10 10-10 Sensitivity Analysis: Changing Sales (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s) Pessimistic CaseSales = $14,000 Optimistic CaseSales = $18,000 NPV = -$426NPV = $3,191

11 10-11 Sensitivity Analysis: Changing Fixed Costs (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s) Pessimistic CaseFixed Costs = $2,500 Optimistic CaseFixed Costs = $1,500 NPV = -$878NPV = $3,643

12 10-12 Limits to Sensitivity Analysis Ambiguous How do you consistently define optimistic or pessimistic? Interrelatedness of variables

13 10-13 Scenario Analysis Scenario Analysis – Project analysis given a particular combination of assumptions. Why is it useful? Simulation Analysis – Estimation of the probabilities of different possible outcomes, e.g., from an investment project. Why is it useful?

14 10-14 Scenario Analysis: Introducing Competition Base Case – No Competition Scenario – Introduce Competition NPV = $1,382 NPV = -$717 Assume that it will take two years for competition to enter the market. At this time, sales drop 10% and variable costs increase to 82% (increased labor demand). What happens to NPV under this scenario? 14,400

15 10-15 Break-Even Analysis Break-Even Analysis - Analysis of the level of sales at which the project breaks even. Why is this useful?

16 10-16 Break-Even Analysis – Example (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s) -Determine the number of units that must be sold in order to break even, on an NPV basis. -Suppose each unit has a price point of $45,000 -All other variables are at their base case levels

17 10-17 Break-Even Point: Accounting Break-Even Point (Accounting) - The break-even point is the number of units sold where net profits = $0. What does the accounting break-even point not account for?

18 10-18 Break-Even Point: Finance NPV Break-Even Point (Finance): How can we find the present value of future cash flows? As long as cash flows are equal each year, we can use the Annuity Factor.

19 10-19 Break-Even Analysis Recall: the break-even point is the number of units sold where NPV = $0.

20 10-20 Operating Leverage Operating Leverage - Degree to which costs are fixed. Degree of Operating Leverage (DOL) - Percentage change in profits given a 1% change in sales.

21 10-21 Operating Leverage: Why is it useful?

22 10-22 Degree of Operating Leverage: Example

23 10-23 Real Options 1.Option to expand 2.Option to abandon 3.Timing option 4.Flexible production facilities

24 10-24 Real Options & the Value of Flexibility Decision Trees – Diagram of sequential decisions and possible outcomes. Decision trees help companies determine their options by showing various choices and outcomes. The option to avoid a loss or produce extra profit has value. The ability to create an option has value that can be bought or sold.

25 10-25 Decision Trees: Example NPV=0 Dont Test New Product Test New Product (Invest $200,000) Success Failure Pursue project NPV=$2million Stop project NPV=0


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