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Chapter 10: Project Analysis

Chapter 10: Project Analysis. How Firms Organize the Investment Process Some “What If” Questions Sensitivity Analysis Scenario Analysis Break Even Analysis Real Options and the Value of Flexibility. Capital Budgeting: The Decision Process. 10.1 Capital Budgeting Problems and Solutions

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Chapter 10: Project Analysis

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  1. Chapter 10: Project Analysis • How Firms Organize the Investment Process • Some “What If” Questions • Sensitivity Analysis • Scenario Analysis • Break Even Analysis • Real Options and the Value of Flexibility

  2. Capital Budgeting: The Decision Process 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities Capital Budget - The list of planned investment projects. The Decision Process • Develop and rank all investment projects = The Capital Budget • Top-Down (strategic planning) • Bottom-Top • Authorize projects based on: • Outlays required by law or company policy (lowest cost) • Maintenance or cost reduction (NPV) • Capacity expansion in existing business (NPV) • Investment for new products (NPV) Chapter 10: Project Analysis

  3. Potential Capital Budgeting Problems 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities • Ensuring forecasts are consistent • Objective macro-economic indicators • Eliminating conflicts of interest • Reward system • Reducing forecast bias • Competition for scarce source • Proper selection criteria (NPV and others) • Competitive advantage Chapter 10: Project Analysis

  4. What-if Testing 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities • 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. Chapter 10: Project Analysis

  5. Sensitivity Analysis 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities • Analysis of the effects on project profitability of changes in sales, costs, etc. • Why is sensitivity analysis useful? • The effect of misestimating a variable on the project Chapter 10: Project Analysis

  6. Sensitivity Analysis: Example 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities • 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 =0 .256 Chapter 10: Project Analysis

  7. Sensitivity Analysis: Example 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities • Possible Range of Variables Chapter 10: Project Analysis

  8. Sensitivity Analysis: Changing Sales 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s) Pessimistic Case—Sales = $14,000 Optimistic Case—Sales = $18,000 NPV = -$426 NPV = $3,191 Chapter 10: Project Analysis

  9. Sensitivity Analysis: Changing Fixed Costs 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s) Pessimistic Case—Fixed Costs = $2,500 Optimistic Case—Fixed Costs = $1,500 NPV = -$878 NPV = $3,643 Chapter 10: Project Analysis

  10. Limits to Sensitivity Analysis 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities • Ambiguous • How do you consistently define “optimistic” or “pessimistic”? • Interrelatedness of variables • Demand-sales • Wages-cost Chapter 10: Project Analysis

  11. Scenario Analysis 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities Scenario Analysis – Project analysis given a particular combination of assumptions. • Why is it useful? • Not absolute • More than one variable can be controlled Simulation Analysis – Estimation of the probabilities of different possible outcomes, e.g., from an investment project. Chapter 10: Project Analysis

  12. Scenario Analysis: Introducing Competition 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities 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? Base Case – No Competition Chapter 10: Project Analysis

  13. Scenario Analysis: Introducing Competition 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities 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? Scenario – Introduce Competition 14,400 (11,808) 142 (57) 85 535 535 Chapter 10: Project Analysis

  14. Break-Even Analysis 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities Break-Even Analysis - Analysis of the level of sales at which the project breaks even. • Make-or-break variable: sales • Accounting Break-Even Analysis The level of sales at which profits are zero; • Finance Break-Even Analysis The level at which NPV is zero; NOTE: If a project is at break-even point in accounting terms, it will have negative NPV. Chapter 10: Project Analysis

  15. Break-Even Point: Accounting 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities (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 Chapter 10: Project Analysis

  16. Break-Even Point: Accounting 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities 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? Chapter 10: Project Analysis

  17. Break-Even Point: Finance 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities 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. Chapter 10: Project Analysis

  18. Break-Even Analysis 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities Recall: the break-even point is the number of units sold where NPV = $0. Chapter 10: Project Analysis

  19. Operating Leverage 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities Operating Leverage - Degree to which costs are fixed. Degree of Operating Leverage (DOL) - Percentage change in profits given a 1% change in sales. Chapter 10: Project Analysis

  20. Operating Leverage 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities Chapter 10: Project Analysis

  21. Degree of Operating Leverage: Example 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities Chapter 10: Project Analysis

  22. Real Options 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities A real option itself, is the right — but not the obligation — to undertake certain business initiatives. Option to expand • Flexibility • Opportunity of cost of abandoning the project • A solution: decision trees 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. Chapter 10: Project Analysis

  23. Decision Trees: Example 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities Year – 0 Year - 1 Pursue project NPV=$1 million Success Test New Product (Invest $100,000) Failure Stop project NPV=0 Don’t Test New Product NPV=0 Chapter 10: Project Analysis

  24. Other Options 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities • Option to abandon • Managers must be flexible to abandon the project • Timing option • Project proposals are option to invest today • Assessment of the project using various information • Flexible production facilities • Avoid becoming dependent on inflexible sources of raw material • Adjust for changing conditions Chapter 10: Project Analysis

  25. Assignments 10.1 • Capital Budgeting • Problems and Solutions 10.2 • “What If” Questions • Sensitivity Analysis • Scenario Analysis 10.3 • Accounting Break-Even Analysis • NPV Break-Even Analysis • Operating Leverage 10.4 • The Option to Expand • A Second Real Option: The Option to Abandon • A Third Real Option: The Timing Option • A Fourth Real Option: Flexible Production Facilities • Read Chapter 11 • Problems (Chapter 10 – Brealy, Myers, and Marcus 6th Edition) 1-10, 16, 17, 20, 21, 24, 25 Note: The slides are based on Brealy, Myers, and Marcus 6th Edition Chapter 10: Project Analysis

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