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McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
MAKING A DECISION
• Beware “Paralysis of Analysis” • At some point you have to make a decision. • If the majority of your scenarios have positive NPVs,
Even • Operating Leverage • Capital Rationing
11-3
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
SCENARIO ANALYSIS
• What happens to the NPV under different cash flow scenarios?
• At the very least, look at:
▪ Best case – high revenues, low costs ▪ Worst case – low revenues, high costs ▪ Measures of the range of possible outcomes
• The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable, and the more attention we want to pay to its estimation.
CHAPTER 11
PROJECT ANALYSIS AND EVALUATION
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
▪ Sources of value – why does this project create value?
11-4
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
• Determine and interpret cash, accounting, and financial break-even points
• Explain how the degree of operating leverage can affect the cash flows of a project
• Click on the Excel icon to see base case, best case, and worst case scenarios results.
11-6
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
SENSITIVITY ANALYSIS
• What happens to NPV when we change one variable at a time?
• This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV.
SUMMARY OF SENSITIVITY ANALYSIS FOR NEW PROJECT
Scenario Base case
Unit Sales 6,000
Cash Flow 63,700
NPV 29,624
IRR 17.8%
Worst case 5,500
55,800
1,147
12.2%
Best case 6,500
KEY CONCEPTS AND SKILLS
• Perform and interpret a sensitivity analysis for a proposed investment
• Perform and interpret a scenario analysis for a proposed investment
SUMMARY OF SCENARIO ANALYSIS
Scenario Net Income Cash Flow NPV
Base case 23,700
63,700
29,624
IRR 17.8%
Worst Case -18,565
21,435
-122,732 -17.7%
Best Case 71,495
• Best case and worst case are not necessarily probable, but they can still be possible.
11-5
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then you can feel reasonably comfortable about accepting the project. • If you have a crucial variable that leads to a negative NPV with a small change in the estimates, then you may want to forego the project.
11-11
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111,495
201,915
47.9%
11-7
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
EVALUATING NPV ESTIMATES
• NPV estimates are just that – estimates.
• A positive NPV is a good start – now we need to take a closer look.
▪ Forecasting risk – how sensitive is our NPV to changes in the cash flow estimates; the more sensitive, the greater the forecasting risk.
• Depreciation is straight-line, the required return is 12%, and the tax rate is 21%.
• The base, lower, and upper values are given for unit sales, price per unit, variable costs per unit, and fixed costs.
71,600
58,102
23.2%
11-9
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SIMULATION ANALYSIS
• Simulation is really just an expanded sensitivity and scenario analysis.
• Monte Carlo simulation can estimate thousands of possible outcomes based on conditional probability distributions and constraints for each of the variables.
11-10
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• The output is a probability distribution for NPV with an estimate of the probability of obtaining a positive net present value.
• The simulation only works as well as the information that is entered, and very bad decisions can be made if care is not taken to analyze the interaction between variables.
• Discuss how capital rationing affects the ability of a company to accept projects
11-2
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CHAPTER OUTLINE
• Evaluating NPV Estimates • Scenario and Other What-If Analyses • Break-Even Analysis • Operating Cash Flow, Sales Volume, and Break-
NEW PROJECT EXAMPLE
• Consider the project discussed in the text in section 11.2.
• The initial cost is $200,000, and the project has a 5-year life. There is no salvage.
