# Chapter 10 Project Analysis

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Chapter 10 Project Analysis
Principles of Corporate Finance Tenth Edition Chapter 10 Project Analysis Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

Topics Covered The Capital Investment Process Sensitivity Analysis
Monte Carlo Simulation Real Options and Decision Trees 2 2 2 2 3 2

Capital Investments Items for consideration
Capital Budget – A list of investment projects under consideration by a firm Do not add fudge factors to the cost of capital Post audits – A review of the project to see how closely it met forewcasts

How To Handle Uncertainty
Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project. Scenario Analysis - Project 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 (or other variable) at which the company breaks even. 6

Sensitivity Analysis Example Given the expected cash flow forecasts for Otobai Company’s Motor Scooter project, listed on the next slide, determine the NPV of the project given changes in the cash flow components using a 10% cost of capital. Assume that all variables remain constant, except the one you are changing. 7

Sensitivity Analysis Example - continued NPV= billion Yen 8

Sensitivity Analysis Example - continued Possible Outcomes 9

Sensitivity Analysis Example - continued
NPV Calculations for Optimistic Market Size Scenario NPV= bil yen 10

Sensitivity Analysis Example - continued NPV Possibilities (Billions Yen) 11

Electric Scooter – NPV

Electric Scooter - Assumptions

Electric Scooter - Scenarios

Electric Scooter – Accounting Profit

Electric Scooter – Cash Flows

Break Even Analysis Point at which the NPV=0 is the break even point
Otobai Motors has a breakeven point of 85,000 units sold. PV Inflows 400 200 19.6 Break even NPV=0 PV (Yen) Billions PV Outflows Sales, 000’s

Break Even Analysis Accounting break even is different, yet wrong. It does not consider the time value of money. Otobai Motors has an accounting breakeven point of 60,000 units sold. 60 40 20 Revenues Break even Profit =0 Accounting revenue and costs (Yen) Billions Costs Sales, 000’s

Operating Leverage Operating Leverage- The degree to which costs are fixed. Degree of Operating Leverage (DOL) - Percentage change in profits given a 1 percent change in sales. 16

Operating Leverage Example – Use the data from the Otobai scooter project.What is the DOL? 18

Monte Carlo Simulation
Modeling Process Step 1: Modeling the Project Step 2: Specifying Probabilities Step 3: Simulate the Cash Flows Step 4: Calculate Present Value

Monte Carlo Simulation

Flexibility & Real Options
Decision Trees - Diagram of sequential decisions and possible outcomes. Decision trees help companies determine their Options by showing the various choices and outcomes. The Option to avoid a loss or produce extra profit has value. The ability to create an Option thus has value that can be bought or sold. 19

Decision Trees Example - FedEx Expansion Option
Exercise delivery option High Demand Observe growth in demand for airfreight Acquire option on future delivery Don’t take delivery Low Demand

Real Options Option to expand Option to abandon Timing option
Flexible production facilities 19

Decision Trees NPV= ? \$700 (.80) \$ 0 (.20) - \$130 .25 \$ 300 (.80)
- \$18 .44 .50 - \$130 Invest Yes / No .56 \$ 0 .25 \$ 100 (.80) \$ 0 (.20) NPV= ? - \$130

Decision Trees NPV= ? \$700 (.80) \$ 0 (.20) - \$130 560 .25 \$ 300 (.80)
- \$18 .44 .50 - \$130 240 Invest Yes / No .56 \$ 0 .25 \$ 100 (.80) \$ 0 (.20) NPV= ? - \$130 80

Decision Trees NPV= ? \$700 (.80) \$ 0 (.20) - \$130 560 .25 \$ 300 (.80)
- \$18 .44 .50 - \$130 240 Invest Yes / No .56 \$ 0 .25 \$ 100 (.80) \$ 0 (.20) NPV= ? - \$130 80

Decision Trees NPV= ? \$700 (.80) \$ 0 (.20) NPV = \$295 - \$130 560 .25
\$ 300 (.80) \$ 0 (.20) - \$18 .44 .50 - \$130 240 Invest Yes / No .56 \$ 0 .25 \$ 100 (.80) \$ 0 (.20) NPV= ? - \$130 80

Decision Trees NPV= ? \$700 (.80) \$ 0 (.20) NPV = \$295 - \$130 560 .25
\$ 300 (.80) \$ 0 (.20) - \$18 .44 .50 - \$130 240 NPV = \$52 Invest Yes / No .56 \$ 0 .25 \$ 100 (.80) \$ 0 (.20) NPV= ? - \$130 80 NPV = - \$69 (do not invest, so NPV = 0)

Decision Trees NPV= ? \$700 (.80) \$ 0 (.20) NPV = \$295 - \$130 560 .25
\$ 300 (.80) \$ 0 (.20) - \$18 .44 .50 - \$130 240 NPV = \$52 Invest Yes / No .56 \$ 0 .25 \$ 100 (.80) \$ 0 (.20) NPV= ? - \$130 80 NPV = - \$69 (do not invest, so NPV = 0)

Decision Trees NPV= \$19 \$700 (.80) \$ 0 (.20) NPV = \$295 - \$130 560 .25
\$ 300 (.80) \$ 0 (.20) - \$18 .44 .50 - \$130 240 NPV = \$52 Invest Yes / No .56 \$ 0 .25 \$ 100 (.80) \$ 0 (.20) NPV= \$19 - \$130 80 NPV = - \$69 (do not invest, so NPV = 0)

Decision Trees NPV= \$19 \$700 (.80) \$ 0 (.20) NPV = \$295 - \$130 560 .25
\$ 300 (.80) \$ 0 (.20) - \$18 .44 .50 - \$130 240 NPV = \$52 Invest Yes / No .56 \$ 0 .25 \$ 100 (.80) \$ 0 (.20) NPV= \$19 - \$130 80 NPV = - \$69 (do not invest, so NPV = 0)

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