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Chapter 8Fundamentals of Corporate FinanceThird Edition
Project
Analysis
Brealey Myers Marcus
slides by Matthew Will
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Topics Covered
?How Firms Organize Their Investment
Process
?Some,What If” Questions
?Sensitivity Analysis
?Break Even Analysis
?Flexibility in Capital Budgeting
?Decision Trees
?Options
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Capital Budgeting Process
Capital Budget - The list of planned
investment projects.
The Decision Process
1 - Develop and rank all investment projects
2 - Authorize projects based on:
? Govt regulation
? Production efficiency
? Capacity requirements
? NPV
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Capital Budgeting Process
?Capital Budgeting Problems
?Consistent forecasts
?Conflict of interest
?Forecast bias
?Selection criteria (NPV and others)
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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,
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Sensitivity Analysis
Example
Given the expected cash flow
forecasts listed on the next
slide,determine the NPV of
the project given changes in
the cash flow components
using an 8% cost of capital,
Assume that all variables
remain constant,except the
one you are changing.
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Sensitivity Analysis
Year 0 Years 1 - 12
Investment - 5,400
Sales 16,000
Variable C osts 13,000
Fixed Cost s 2,000
Depreciati on 450
Pretax pro fit 550
,Taxes @ 40% 220
Profit aft er tax 330
Operating cash flow 780
Net Cash F low - 5,400 780
Example - continued
NPV= $478
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Sensitivity Analysis
Example - continued
Possible Outcomes
Range
Variable Pessimisti c Expected Optimistic
Investment (000s) 6,200 5,400 5,000
Sales(000s ) 14,000 16,000 18,000
Var Cost ( % of sales ) 83% 81.25% 80%
Fixed Cost s(000s) 2,100 2,000 1,900
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Sensitivity Analysis
Example - continued
NPV Calculations for Pessimistic Investment Scenario
Year 0 Years 1 - 12
Investment - 6,200
Sales 16,000
Variable C osts 13,000
Fixed Cost s 2,000
Depreciati on 450
Pretax pro fit 550
,Taxes @ 40% 220
Profit aft er tax 330
Operating cash flow 780
Net Cash F low - 6,200 780
NPV= ($121)
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Sensitivity Analysis
Example - continued
NPV Possibilities
NPV s
Variable Pessimisti c Expected Optimistic
Investment
( )000
(000s) - 121 478 778
Sales(000s ) - 1,218 478 2,174
Var Cost ( % of sales ) - 788 478 1,382
Fixed Cost s(000s) 26 478 930
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Break Even Analysis
Example
Given the forecasted data
on the next slide,
determine the number of
planes that the company
must produce in order to
break even,on an NPV
basis,The company’s cost
of capital is 10%.
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Break Even Analysis
Year 0 Years 1 - 6
Investment $900
Sales 15.5xPlane s Sold
Var,Cost 8.5xPlanes Sold
Fixed Cost s 175
Depreciati on 900 / 6 = 150
Pretax Pro fit (7xPlanes Sold) - 325
Taxes (50% ) (3.5xPlane s Sold) - 162.5
Net Profit (3.5xPlane s Sold) - 162.5
Net Cash F low - 900 (3.5xPlane s Sold) - 12.5
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Break Even Analysis
Answer
The break even point,is the # of Planes
Sold that generates a NPV=$0,
The present value annuity factor of a 6
year cash flow at 10% is 4.355
Thus,
NPV xPlanes So= -900 + 4 355 3 5,(, ld - 12.5)
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Answer
Solving for,Planes Sold”
0 4 355 3 5= -900 +, (, ld - 12.5)xPlanes So
Planes Sol d = 63
Break Even Analysis
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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,
DOL = % change i n profits% change i n sales
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Operating Leverage
Example - A company has sales outcomes that range from
$16mil to $19 mil,Depending on the economy,The same
conditions can produce profits in the range from $550,000
to $1,112,000,What is the DOL?
DOL = = 5, 4 51 0 2, 21 8, 7 5
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Flexibility & 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.
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Decision Trees
NPV=0
Don’t test
Test (Invest
$200,000)
Success
Failure
Pursue project
NPV=$2million
Stop project
NPV=0