Revisiting Cash Flows

and NPV estimates

Main source: Ross et.al. Ch.11
Learning Objectives
1. Project’s NPV: some problems
2. Scenario Analysis
3. Sensitivity Analysis
4. Break-even Analysis: Accounting
5. Break-even Cash Flows
6. Degree of Operating Leverage
7. Capital Rationing
▪ (+) NPV → market value > costs

▪ NPV focus on value creation for

the owners

▪ But NPV is just an estimate

means: close to the true value
Basic Problem
Even if we have done all of the best practices:
• Avoid sunk costs
• Consider working capital requirement
• Add back any depreciation
• We account possible side effects
• Pay attention to opportunity costs
• After taxes
• Double check all calculations, and
• Get positive NPV, it is a good sign
We still need to take a closer look and recheck it…!
Positive NPVs may have two
possibilities:

The project may appear

The project really does
to have a positive NPV
have a positive NPV (it is
because our estimate is
the good news)
inaccurate
Projected vs. Actual Cashflows

Almost anything could

Our projection is
happen between now
based on what we
and then to change
know today
that cashflows
FORECASTING RISK
Definition: the possibility that errors in projected
cashflows will lead to incorrect decisions.
There is a danger that we will think a project has a
positive NPV when it really does not.
How is this possible?
If we are overly optimistic about the future, as a result
our projected cashflows do not realistically reflect the
possible future cashflows.
It is important to develop some tools that are useful in
identifying areas where potential errors exist and
where they might be especially damaging.
SOURCES OF VALUE
A. Is our product/service significantly
better?
B. Can we manufacture at lower cost?
C. Or distribute more effectively?
D. Or identify undeveloped market niches?
E. Or gain control of a market?
F. Degree of competition - currently
G. Potential competition - new entrant

If we can’t articulate some sound economic

basis of thinking ahead of time that we have
found something special, then the conclusion
that our project has a positive NPV should be
subjected to further analysis and evaluation.
 To assess the degree of forecasting
risk and to identify the most critical
component of the success or failure
of an investment.
WHAT-IF Our first step: Calculate NPV based
on our projected cashflow → we
ANALYSES call this as BASE CASE
Next step: What is the impact of
different assumption about the
future of our estimates
Upper bound and Lower bound
UPPER BOUND

BASE CASE

LOWER BOUND

Base Case Lower Bound Upper Bound

Unit Sales 6000 5500 6500
Price/unit $ 80 $ 75 $ 85
Variable cost/unit $ 60 $ 58 $ 62
Fixed costs/year $ 50.000 $ 45.000 $ 55.000
Scenario Analysis
BEST CASE

BASE CASE

WORST CASE

Base Case Worst Case Best Case

Unit Sales 6000 5500 6500
Price/unit $ 80 $ 75 $ 85
Variable cost/unit $ 60 $ 62 $ 58
Fixed costs/year $ 50.000 $ 55.000 $ 45.000
Scenario Analysis
Base Case Worst Case Best Case
Unit Sales 6000 5500 6500
Price/unit $ 80 $ 75 $ 85
Variable cost/unit $ 60 $ 62 $ 58
Fixed costs/year $ 50.000 $ 55.000 $ 45.000
↓ ↓ ↓
Sales $ 480.000
Total VC 360.000
Fixed Cost 50.000
Depreciation 40.000
EBIT $ 30.000
Taxes (34%) 10.200
Net Income $ 19.800 $ -15.510 $ 59.730
OCF $ 59.800 $ 24.490 $ 99.730
NPV $ 15.567 $ -111.719 $ 159.504
IRR 15,1% - 14,4% 40,9%
Another example:

Scenario Analysis
OPTIMISTIC

BASE CASE

PESSIMISTIC

Conclusion on the Scenario Analyses:

It is useful in telling what is the potential disaster,
but it does not tell whether to take a project
Exercise: Scenario analysis

Soal No. 27 halaman 405

 What happen to the
NPV when only one
variable is changed.
Sensitivity
Analysis “How sensitive is the
NPV to changes in
certain component
of project cash flow.”
Sensitivity Analysis
Examples:
A. Freeze every item except UNIT SALES
Scenario Unit Sales OCF NPV IRR
Base Case 6000 $ 59.800 $ 15.567 15,1%
Worst Case 5500 53.200 - 8.226 10,3%
Best Case 6500 66.400 39.357 19,7%

B. Freeze every item except FIXED COSTS

Scenario Fixed Cost OCF NPV IRR
Base Case $ 50.000 $ 59.800 $ 15.567 15,1%
Worst Case 55.000 56.500 3.670 12,7%
Best Case 45.000 63.100 27.461 17,4%
As a form of SCENARIO ANALYSIS,
SENSITIVITY ANALYSIS is useful for pointing out where
forecasting errors will do the most damage, but does not tell
what to do about possible errors.
Exercise: Sensitivity analysis

Soal No. 28 halaman 405

 It is a combination of
scenario and sensitivity
analysis.
It is difficult to use (it is a
SIMULATION
complicated tool), the use
ANALYSIS is limited in practice.
Need a computer to do it,
and suitable for large
project.
Break-even Analysis
Example from Ch.9:
The length of time until a project breaks even,
ignoring time value → Payback Period.
Next we will find:
• Accounting break-even
• Cash break-even
• Financial break-even
Fixed and Variable costs
Variable cost: costs that change when the quantity of
output changes
Examples: direct labor costs, direct (raw) material
We will assume: that variable cost is a constant amount
per unit of output
Total VC = Total Q of output x VC per unit of output
VC = Q x v

Fixed costs: costs that do not change when the quantity

of output changes during a particular time period
Fixed and Variable costs
Example of Fixed Costs:
FC do not change during a specified time period. FC
do not depend on the amount of goods and services
produced during a period (at least within some range
of production capacity)
• Lease payment on a production facility
• President’s salary
Fixed costs are not fixed forever, only during some
particular time. In the long-run all costs are variable.
Total Costs
Total Costs: for a given level of output are the sum of
VC and FC
Example: variable cost per unit $3.00 and fixed costs
per year $8.000
Quantity Produced Total Variable Cost Fixed Costs Total Costs
0 $0 $ 8.000 $ 8.000
1000 3.000 8.000 11.000
5000 15.000 8.000 23.000
6000 18.000 8.000 26.000
10000 30.000 8.000 38.000
Marginal Cost, Average Cost and
Marginal Revenue
Marginal Cost: The change in costs that occurs when
there is a small change in output
Marginal Cost = variable cost per unit
Average Costs = AC = TC/Q
Marginal Revenue: The change in revenue that
occurs when there is a small change in output
Marginal Revenue = price per unit
VC, FC and TC

TC
TC, VC, FC

VC

FC

0 Q
Accounting Break Even
The sales level that results in zero project net income
Sales 450 units x $ 5 $ 2250
VC 450 x $ 3 1350
FC 600
Depr 300
EBIT 0
Taxes (34%) 0
NI 0

FC = $ 600
Price of output = $5; Price of Inventory = $3
(P – v) = $2 → Contribution Margin
Accounting Break Even
Revenue
$5 per unit
Sales, Costs
Total Costs (= TC)
= $900 + $3/unit

$2250

$900 FC + D

Q
450 units
Accounting Break Even
P = selling price / unit Sales
v = variable cost / unit - VC
Q = unit sold (sales volume) - FC
S = (total) sales = P x Q - Depr
VC = total vc = v x Q EBIT
FC = fixed costs per period - EBIT x T
D = depreciation EBIT x (1 – T) = NI
T = tax rate

At Break-even:
(S – VC – FC – D)(1 – T) = NI = 0
Only at BE: ignoring tax
S – VC – FC – D = 0 → S – VC = FC + D → Q(P – v) = FC + D
→ Q*= (FC + D)/(P – v) ← Accounting BE quantity
Sales Volume vs. OCF
OCF = EBIT – Taxes + D
= EBIT (1 – T) + D
= (S – VC – FC – D)(1 – T) + D
= [(P – v)Q – FC – D](1 – T) + D
Ignoring tax:
OCF = (P – v)Q – FC – D + D
OCF = (P – v)Q – FC
OCF = (P – v)Q – FC
Jika diketahui: P = $40; v = $20; FC = $500
OCF = ($40 - $20)Q - $500
OCF = -$500 + $20*Q
Hubungan linier antara OCF dengan Q, slope = $20
Slope = contribution margin
Quantity Sold (Q) OCF
0 - $500
15 - $200
30 $100
50 $500
75 $1,000
Accounting, Cash & Financial
Break-even
Re-written:
OCF = [(P – v)Q – FC – D](1 – T) + D
OCF = (P – v)Q(1 – T) – FC(1 – T) – D(1 – T) + D
(P – v)Q(1 – T) = OCF + FC(1 – T) – DT
Q = [FC(1 – T) + OCF – DT] / (P – v)(1 – T)
Ignore tax: Q = (FC + OCF)/(P – v) →OCF = NI + D
Accounting Break-even: NI = 0 → OCF = D
Q* = (FC + D) / (P – v)
Accounting, Cash & Financial
Break-even
Cash Break-even: sales volume that OCF = 0
Q = (FC + OCF)/(P – v) →Q = FC /(P – v)
Financial break-even: Q where NPV = 0
Ilustrasi: -I0 = $3,500, i=20%, n=5, PVIFA = 2.9906
NPV = 0 → I0 = OCF x PVIFA→3500 = OCF x 2.9906
OCF = 3500/2.9906 = $1.170
Q = [(FC(1 – T) + OCF – DT]/(P – v)(1 – T)
Ignoring tax: Q = (FC + OCF*)/(P – v)
OCF* adalah OCF at NPV = 0
Q =($500 + $1170)/$20 = 83,5 units
Ordinary vs Discounted Payback
I0 = $300, r = 12.5%, NPV=$55
Cash Flow Accumulated Cash Flow
Year Undiscounted Discounted Undiscounted Discounted
1 $ 100 $89 $100 $89
2 100 79 200 168
3 100 70 300 238
4 100 62 400 300
5 100 55 500 355

If I0=$355→NPV=0→Discounted Payback = 5 or equal to

the maturity date of the project
Summary of BE measures:
OCF = (Sales – VC – FC – D)(1 – T) + D
OCF = [(P –v)Q – FC – D)(1 – T) + D
OCF = (P –v)Q(1 – T) – FC(1 – T) – D(1 – T) + D
Q = [FC(1 – T) + OCF – DT]/(P – v)(1 – T)
Ignoring tax: Q = (FC + OCF)/(P – v)
Accounting BE: NI = 0 → OCF = NI + D → OCF = D
Q = [FC(1 – T) + D – DT]/(P – v)(1 – T)
Ignoring tax: Q = (FC + D)/(P – v)
Summary of BE measures:
Cash BE: OCF = 0
Q = [FC(1 – T) – DT]/(P – v)(1 – T)
Ignoring tax: Q = FC / (P – v)
Financial BE: NPV = 0 → OCF* when NPV = 0
Q = [FC(1 – T) + OCF* - DT]/(P – v)(1 – T)
Ignoring tax: Q = (FC + OCF*)/(P – v)
1. Discounted payback equal to its life
2. NPV = 0
3. IRR = r
Exercise: Break-even analysis

Soal No. 25 & 29 halaman 405

Operating Leverage
By definition: The degree to which a firm or a project
relies on fixed costs
Low operating leverage = low fixed costs
Project with heavy investment in Plant & Equipment will
have a high degree of operating leverage
High investment in P&E = Capital Intensive → high DOL
Higher investment in P&E → higher FC & Depr → higher
DOL
Increase in FC → smaller % increase in operating revenue
→ larger % increase in OCF and NPV
Operating Leverage
The higher the DOL →the greater is the potential
danger from FORECASTING RISK
It means: small errors in forecasting sales volume
can get “levered up” into large errors in cash flow
projection
Important: One way of coping with highly uncertain
projects is to keep the DOL as low as possible. This
will have the effect of keeping BEP at its minimum
level.
Visualized
TR TR

TC TC

FC

FC

0 Q* 0 Q*
Higher Fixed costs Lower Fixed costs
Degree of Operating Leverage
DOL = % change in OCF/% change in Q
Definition: %change in OCF = DOL x %change in Q
(P – v)/OCF = DOL x (1/Q)
DOL = [(P – v)Q]/OCF
Since: Q = (FC + OCF)/(P – v) → OCF + FC = (P – v)Q
So: DOL = (OCF + FC)/OCF → DOL = 1 + (FC/OCF)
FC/OCF is higher when FC is higher, and also 1 + FC/OCF
or its DOL
If: FC = 0 → DOL = 1 →no leverage
Conclusion: DOL is lower when FC as % of OCF is lower
Degree of Operating Leverage
Example: P=$40.000, v=$20.000, FC=$500.000,
I0=$3.500.000, Sales projection: 85 boats/year
First option: NPV = $88.720 (at 20% and 85 boats)
Accounting BE = 60 boats → DOL = 1.42
Other option: Subcontract hull assembly,
I0=$3.200.000, FC=$180.000, v=$25.000,
NPV at 20% and 85 boats = $74.720
Accounting BE = 55 boats
DOL = 1.16
When Capital Budget is limited
Capital Rationing: the situation that exist if a firm has
positive NPV projects but cannot find the necessary
financing.
Soft rationing: the situation that occurs when units in a
business are allocated a certain amount of financing for
capital budgeting
Example:
Identify $5.000.000 excellent projects
Budget is only $2.000.000
First: try to get larger budget
Second: generate max NPV within existing budget by
choosing the larger Profitability Index
Exercise: Operating Leverage

Soal No. 26 & 30 halaman 405