1. 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

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

3. 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

4. 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

5. 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

6. Sensitivity Analysis
Example - continued
NPV= billion Yen 8

7. Sensitivity Analysis
Example - continued Possible Outcomes 9

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

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

10. Electric Scooter – NPV

11. Electric Scooter - Assumptions

12. Electric Scooter - Scenarios

13. Electric Scooter – Accounting Profit

14. Electric Scooter – Cash Flows

15. 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

16. 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

17. 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

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

19. 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

20. Monte Carlo Simulation

21. 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

22. 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

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

24. 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

25. 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

26. 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

27. 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

28. 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)

29. 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)

30. 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)

31. 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)

32. Web Resources Click to access web sites Internet connection required