Lecture Outline

Lecture 15

Lecture Organization
Operating Leverage
Additional Considerations in Capital
Budgeting
Capital Budgeting Questions

Projected versus Actual Cash Flows

Capital Budgeting Questions

Forecasting Risk

Forecasting risk

In order to develop reliable cash flow

estimates for the projects we have to
understand (among other things)
Quantity Analysis

How sensitive the cash flows to changes

in quantity?
OPERATING LEVERAGE

Operating leverage

Operating leverage
Example of Different DOL projects
Example: comparison two alternative cost structures for
project A and B;
Project A: FC(Proj. A) =$10,000; VC(Proj. A) = $6, Unit Price=$10
Project B: FC(Proj. B) =$25,000; VC(Proj. B) =$3, Unit Price=$10

consider what minimum quantity of sales Q* would be

required to favor one project over another.

Solution
Example of Different DOL projects

OCF

$20,000

$10,000

$0
Quantity
2,500 5,000 10,000

$10,000

-$25,000
OPERATING LEVERAGE

Implications of Operating Leverage

The higher the degree of operating leverage,
the

In general, the lower the fixed costs and the

degree of operating leverage
OPERATING LEVERAGE

Measuring Operating Leverage

Degree of operating leverage (DOL)degree to which

% change in Q affects OCF.

DOL=

DOL =
Fairways Driving Range DOL

DOL is

For Fairways: Ignoring taxes

DOL =
DOL

Three points should be kept in mind:

Higher DOL suggests

Operational Leverage is

Hi fixed costs make good situations

DOL declines as
Problem

A proposed project has fixed costs of $20,000 per year.

OCF at 7,000 units is $55,000.
Ignoring taxes, what is the degree of operating leverage
(DOL)?
DOL =
If units sold rises from 7,000 to 7,300, what will be the
increase in OCF?

What is the new DOL?

Managerial Options and Capital Budgeting

Managerial options and capital budgeting

What is ignored in a static DCF analysis?

Contingency planning

Capital Rationing
Managerial Options and Capital Budgeting

Contingency planning
 Capital Rationing

Capital Rationing Definition: