1. copyright © 2003 McGraw Hill Ryerson Limited 8-1 prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology Fundamentals of Corporate Finance Second Canadian Edition

2. copyright © 2003 McGraw Hill Ryerson Limited 8-2 Chapter 8 Project Analysis Chapter Outline  How Firms Organize the Investment Process  Some “What If” Questions  Break-Even Analysis  Flexibility in Capital Budgeting  Capital Budgeting Practices in Canadian Firms

3. copyright © 2003 McGraw Hill Ryerson Limited 8-3 The Investment Decision How Firms Organize the Investment Process  Once a year, a firm’s head office will generally ask each of its divisions to provide a list of the investments they would like to make.  A list of planned investments is known as the capital budget. This “wish list” must then be examined to determine which projects should go forward. How is this done?

4. copyright © 2003 McGraw Hill Ryerson Limited 8-4 Some “What If” Questions Introduction  Managers want to understand more than the NPV of a project.  They also want to predict what events could happen and how that might affect NPV. Once they have done this, management can decide if it is worthwhile investing more time and effort in understanding the uncertainty and trying to resolve it.

5. copyright © 2003 McGraw Hill Ryerson Limited 8-5 Some “What If” Questions Introduction  There are five methods managers use to handle project uncertainty: Sensitivity Analysis Scenario Analysis Simulation Analysis Break-Even Analysis Operating Leverage Analysis

6. copyright © 2003 McGraw Hill Ryerson Limited 8-6 Some “What If” Questions Sensitivity Analysis  A sensitivity analysis calculates the consequences of incorrectly estimating a variable in your NPV analysis.  If forces you: To identify the variables underlying your analysis. To focus on how changes to these variables could impact the expected NPV. To consider what additional information should be collected to resolve uncertainties about the variables.

7. copyright © 2003 McGraw Hill Ryerson Limited 8-7 Some “What If” Questions Sensitivity Analysis  Suppose, as a financial manager, you have estimated the cash flow forecasts for a new grocery store. These are shown on on the next slide.  The project has a positive NPV of $478,000.  Before you recommend the project to your boss, you want to analyze the forecast and identify the key variables which will determine whether the project succeeds or fails.

8. copyright © 2003 McGraw Hill Ryerson Limited 8-8 Some “What If” Questions

9. copyright © 2003 McGraw Hill Ryerson Limited 8-9 Some “What If” Questions Sensitivity Analysis  You want to look at how the NPV of the project may be affected by an incorrect forecast of sales, costs, etc.  You develop the optimistic and pessimistic estimates for the underlying variables which are shown on the next slide.

10. copyright © 2003 McGraw Hill Ryerson Limited 8-10 Some “What If” Questions Sensitivity Analysis  You will use the estimates below, one at time, to recalculate NPV:

11. copyright © 2003 McGraw Hill Ryerson Limited 8-11 Some “What If” Questions Sensitivity Analysis  For example, if the initial investment in the project were $6.2 million, instead of $5.4 m, you would recalculate NPV as: NPV= PV of Cash Flows - Investment (C 0 ) = [$806,667 x 12 year annuity factor] - 6.2 m = [$806,667 x 7.536] – 6.2 m = -$120,897 * * Don’t forget to change the depreciation for the project!

12. copyright © 2003 McGraw Hill Ryerson Limited 8-12 Some “What If” Questions Sensitivity Analysis  After all the recalculations, you would have the following estimates:

13. copyright © 2003 McGraw Hill Ryerson Limited 8-13 Some “What If” Questions Sensitivity Analysis  You now know how badly the project could be thrown off course by changes in certain variables.  Looking at the table on the previous slide, can you answer the following questions: What is the least critical variable to the success of the project? What are the two most critical variables to the success of the project?

14. copyright © 2003 McGraw Hill Ryerson Limited 8-14 Some “What If” Questions Sensitivity Analysis  Did you identify fixed costs as the least critical variable? Even under the pessimistic assumption about fixed costs, the project has a positive NPV, so it is unlikely to give you trouble if you have estimated it incorrectly.  Did you identify sales and variable costs as the most critical variables? A poor estimate of either of these could lead to a significantly negative NPV for the project.

15. copyright © 2003 McGraw Hill Ryerson Limited 8-15 Some “What If” Questions Sensitivity Analysis  Now that you have identified the critical success/failure factors, you may wish to focus your attention on them: You might collect additional data on sales and costs so as to resolve some of the uncertainty concerning these variables.

16. copyright © 2003 McGraw Hill Ryerson Limited 8-16 Some “What If” Questions Sensitivity Analysis  Sensitivity analysis is not a “cure-all”.  It does have its drawbacks: The results are ambiguous since the terms “optimistic” and “pessimistic” are completely subjective. Variables are often related and it may be difficult to identify all of the consequences associated with a change in one of them.

17. copyright © 2003 McGraw Hill Ryerson Limited 8-17 Some “What If” Questions Scenario Analysis  A scenario analysis involves changing several variables at once in your NPV forecast. See Example 8.2

18. copyright © 2003 McGraw Hill Ryerson Limited 8-18 Some “What If” Questions Simulation Analysis  A simulation analysis uses a computer to generate hundreds, or even thousands, of possible scenarios.  A probability distribution is assigned to each combination of variables to create an entire range of potential outcomes.

19. copyright © 2003 McGraw Hill Ryerson Limited 8-19 Break-Even Analysis Accounting vs NPV Break-Even Analysis  A Break-Even analysis shows the level of sales at which a company “breaks even”. An accounting break-even occurs where total revenues equal total costs (profits equal zero). A NPV break-even occurs when the NPV of the project equals zero.  Using accounting break-even can lead to poor decisions. You can avoid this risk by using NPV break-even in your analysis!

20. copyright © 2003 McGraw Hill Ryerson Limited 8-20 Break-Even Analysis Accounting Break-Even  An accounting break-even occurs where total revenues equal total costs, and thus profits are zero.  How do we calculate this point?

21. copyright © 2003 McGraw Hill Ryerson Limited 8-21 Break-Even Analysis Accounting Break-Even  Go back to the cash flow analysis you did on Slide #8: You estimated sales to be $16 million. Variable costs were 81.25% of sales ($0.8125 of variable costs per $1 of sales). Fixed costs were $2 million and depreciation was $450,000.  These variables are all you need to calculate accounting break-even!

22. copyright © 2003 McGraw Hill Ryerson Limited 8-22 Break-Even Analysis Accounting Break-Even  Accounting break-even is calculated as: Break-Even Revenues= Fixed Costs + Depreciation Profit per $1 of Sales = $2,000 + $450 $1 - $0.8125 = $2,450 $0.1875 = $13.067 million

23. copyright © 2003 McGraw Hill Ryerson Limited 8-23 Break-Even Analysis Accounting Break-Even  Creating an income statement at $13.067 million of sales shows profit equals zero: Revenues$13,067 Variable Costs10,067 Fixed Costs + Depreciation2,450 Pretax Profit 0 Taxes 0 Profit after Tax 0

24. copyright © 2003 McGraw Hill Ryerson Limited 8-24 Break-Even Analysis Accounting Break-Even  If a project breaks even in accounting terms is it an acceptable investment?  Clue: This project has a 12 year life … Would you be happy with an investment which after 12 years gave you a zero total rate of return?

25. copyright © 2003 McGraw Hill Ryerson Limited 8-25 Break-Even Analysis Accounting Break-Even  A project which simply breaks even on an accounting basis will always have a negative NPV! Proof: NPV= PV of Cash Flows – C 0 = [$450,000 * (12 year Annuity Factor)] - $5.4 m  $0 Note: the 12 year Annuity Factor  12 for all discount rates! CFO= profit after tax + depreciation = $0 + $450,000 = $450,000

26. copyright © 2003 McGraw Hill Ryerson Limited 8-26 Break-Even Analysis NPV Break-Even  Asking how bad sales can get before a project makes an accounting loss is not the best tool for analysis of a project.  Instead, it is more useful to focus on the point at which NPV switches from negative to positive.  Let’s develop a method for calculating this NPV break-even!

27. copyright © 2003 McGraw Hill Ryerson Limited 8-27 Break-Even Analysis NPV Break-Even  Going back to our example:  Pretax Profit (0.1875 Sales) - 2.45 m Note: Cash flow = Depreciation + After Tax Profit Variable Costs81.25% of Sales + Fixed Costs + Depreciation$2.45 m - Tax @ 40%0.40 x [(0.1875 Sales) - 2.45 m]  After Tax Profit 0.60 x [(0.1875 Sales) - 2.45 m]  Cash flow $0.45 m + 0.60 x [(0.1875 Sales) - 2.45 m] = 0.1125 * Sales - $1.02 m

28. copyright © 2003 McGraw Hill Ryerson Limited 8-28 Break-Even Analysis NPV Break-Even  This cash flow will last for 12 years. But: NPV = 0 if PV (cash flows) = C 0  NPV = 0 if (0.1125 x Sales – 1.02 m) x 7.536 = 5.4 m  Sales = $15.4 m  PV(cash flows) = Cash Flows x Annuity Factor = (0.1125 x Sales - 1.02 m) x 12 year Annuity Factor = (0.1125 x Sales - 1.02 m) x 7.536

29. copyright © 2003 McGraw Hill Ryerson Limited 8-29 Break-Even Analysis NPV Break-Even  Using the accounting break-even, the project had to generate sales of $13.067 million to have zero profit.  Using the NPV break-even, we find that the project needs sales of $15.4 million to have a zero NPV. The project needs to be 18% more successful to break-even on a NPV basis!

30. copyright © 2003 McGraw Hill Ryerson Limited 8-30 Break-Even Analysis Degree of Operating Leverage (DOL)  Let’s say you are predicting a 1% change in the sales of your firm. How will that change affect your firm’s profits? 1)A 1% change in sales could lead to a 1% change in profits.  This would be a very stable situation. 2)Or, it could lead to a 50% change in profits.  This would be a very risky and volatile situation.

31. copyright © 2003 McGraw Hill Ryerson Limited 8-31 Break-Even Analysis Degree of Operating Leverage (DOL)  Operating leverage is a measure of the percentage of a firm’s costs that are fixed.  Degree of Operating Leverage (DOL) measures the percentage change in profits given a 1% change in sales. If DOL = 1, then a 1% change in sales will produce a 1% change in profits. If DOL = 50, then a 1% change in sales will produce a 50% change in profits.

32. copyright © 2003 McGraw Hill Ryerson Limited 8-32 Break-Even Analysis Degree of Operating Leverage (DOL)  There are two ways of measuring DOL: Note that the level of fixed costs in a company will determine DOL and how volatile its profits are in response to a change in sales. DOL= percentage change in profits percentage change in sales DOL= 1 + fixed costs profits

33. copyright © 2003 McGraw Hill Ryerson Limited 8-33 Break-Even Analysis Degree of Operating Leverage (DOL)  If you examine Table 8.4 on page 256, you will see that the risk of a project is affected by its DOL. If a large proportion of the project’s costs are fixed, then DOL will be high. If DOL is high, then any shortfall in sales will have a magnified effect on profits.  In other words, high DOL means high risk if sales do not work out as forecasted!

34. copyright © 2003 McGraw Hill Ryerson Limited 8-34 Flexibility in Capital Budgeting The Value of Having Options  No matter how much analysis you do on a project, it is impossible to completely eliminate uncertainty.  Can you think of any way: To mitigate the effect of unpleasant surprises. and To take advantage of pleasant ones?

35. copyright © 2003 McGraw Hill Ryerson Limited 8-35 Flexibility in Capital Budgeting The Value of Having Options  Because the future is uncertain, successful financial managers seek projects with flexibility.  The perfect project would have: The option to expand if things go well. The option to bail out or switch production if things go poorly. The option to postpone if future conditions might improve.

36. copyright © 2003 McGraw Hill Ryerson Limited 8-36 Flexibility in Capital Budgeting The Value of Having Options  Options to avoid a loss, switch production or abandon a project; to expand and produce extra profit; or to postpone action have significant value for a firm.  Good outcomes can be exploited, while poor outcomes can be avoided or postponed.

37. copyright © 2003 McGraw Hill Ryerson Limited 8-37 Flexibility in Capital Budgeting The Value of Having Options  Decision trees are used to diagram the options in a project. You can then determine the optimal course of action from a series of potential options.  A decision tree is defined as a diagram of sequential decisions and their possible outcomes. Figure 8.3 is an example of a decision tree.

38. copyright © 2003 McGraw Hill Ryerson Limited 8-38 Flexibility in Capital Budgeting The Value of Having Options  As a general rule, flexibility will be most valuable to you when the future is most uncertain.  The ability to change course as events develop and new information becomes available is most valuable when it is hard to predict with confidence what the best course of action will be.

39. copyright © 2003 McGraw Hill Ryerson Limited 8-39 Canadian Practices Capital Budgeting Practices in Canadian Firms  In Table 8.7 on page 262, you can see how Canadian firms are actually making capital budgeting decisions.  Most firms use multiple methods for analyzing a project’s acceptability.  Note that discounted cash flow techniques were used by more than 75% of respondents.

40. copyright © 2003 McGraw Hill Ryerson Limited 8-40 Summary of Chapter 8  Successful managers know that the forecasts behind NPV calculations are imperfect.  Thus, they explore the consequences to the firm of a poor forecast.  They check whether the project is really worth pursuing by doing some additional homework. This consists of asking a series of “what-if” questions to determine the feasibility of the project and its risk profile.

41. copyright © 2003 McGraw Hill Ryerson Limited 8-41 Summary of Chapter 8  The principal tools used by managers in “what-if” questions are: Sensitivity Analysis Scenario Analysis Simulation Analysis Break-Even Analysis Operating Leverage  A desirable characteristic in a project is flexibility.

42. copyright © 2003 McGraw Hill Ryerson Limited 8-42 Summary of Chapter 8  Projects with options to expand, abandon, switch production, or postpone actions may have added value to the firm.  You can use decision trees to analyze such flexibility.  A survey of Canadian firms shows that most use multiple capital budgeting methods to assess projects.