Lecture 3

Project Analysis
 Topics Covered
• The Capital Investment Process
• Sensitivity Analysis
• Monte Carlo Simulation
• Real Options and Decision Trees
 Capital Investments
• Items for consideration
Capital Budget – A list of investment projects
under consideration by a firm

Do not add fudge factors to the cost of capital

Post audits – A review of the project to see how

closely it met forecasts
 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.
 Sensitivity Analysis
Example
Given the expected cash flow
forecasts for Otobai Company’s
Motor Scooter project, listed on
the next slide, determine the
NPV of the project given
changes in the cash flow
components using a 10% cost of
capital. Assume that all
variables remain constant,
except the one you are
changing.
 Sensitivity Analysis
Example - continued
Year 0 Years 1 - 10
Investment - 15
Sales 37.5
Variable Costs 30
Fixed Costs 3
Depreciati on 1.5
Pretax profit 3
.Taxes @ 50% 1.5
Profit after tax 1.5
Operating cash flow 3.0
Net Cash Flow - 15 3
NPV= 3.43 billion Yen
 Sensitivity Analysis
Example - continued

Possible Outcomes
Range
Variable Pessimistic Expected Optimistic
Market Size .9 mil 1.0 mil 1.1 mil
Market Share .04 .1 .16
Unit price 350,000 375,000 380,000
Unit Var Cost 360,000 300,000 275,000
Fixed Cost 4 bil 3 bil 2 bil
 Sensitivity Analysis
Example - continued
NPV Calculations for Optimistic Market Size Scenario
Year 0 Years 1 - 10
Investment - 15
Sales 41.25
Variable Costs 33
Fixed Costs 3
Depreciation 1.5
Pretax profit 3.75
.Taxes @ 50% 1.88
Profit after tax 1.88
NPV= +5.7 bil yen
Operating cash flow 3.38
Net Cash Flow - 15  3.38
 Sensitivity Analysis
Example - continued

NPV Possibilities (Billions Yen)

Range
Variable Pessimistic Expected Optimistic
Market Size 1.1 3.4 5.7
Market Share - 10.4 3.4 17.3
Unit price - 4.2 3.4 5.0
Unit Var Cost - 15.0 3.4 11.1
Fixed Cost 0.4 3.4 6.5
Scenario Analysis - Assumptions

Assumptions
High Oil Prices and
Base Case Recession Case
Market size 1 million .8 million
Market share 0.1 0.13
Unit Price 375000 431300
Unit variable cost 300000 345000
Fixed cost 3 billion 3.5 billion
 Scenario Analysis - NPV
Cash Flows, Years 1-10, Billions
High Oil Prices and
Base Case Recession Case
1 Revenue 37.5 44.9
2 Variable cost 30.0 35.9
3 Fixed cost 3.0 3.5
4 Depreciation 1.5 1.5
5 Pretax profit (1-2-3-4) 3.0 4.0
6 Tax 1.5 2.0
7 Net profit (5-6) 1.5 2.0
8 Net cash flow (4+7) 3.0 3.5

PV of cash flows 18.4 21.4

NPV 3.4 6.4
 Electric Scooter - Scenarios

Inflows Outflows
Year 0 Years 1-10
Unit Sales, Revenue, Variable Fixed PV
Thousands Years 1-10 Investment Costs Costs Taxes PV Inflows Outflows NPV
0 0 15 0 3 -2.25 0 19.6 -19.6
100 37.5 15 30 3 1.5 230.4 227 3.4
200 75 15 60 3 5.25 460.8 434.4 26.5

Breakeven point must be somewhere between 0 and 100

 Electric Scooter – Accounting Profit

Unit Sales, Variable Fixed Total Profit

Thousands Revenue Costs Costs Depreciation Taxes Costs after Tax
0 0 0 3 1.5 -2.25 2.25 -2.25
100 37.5 30 3 1.5 1.5 36 1.5
200 75 60 3 1.5 5.25 69.75 5.25
 Electric Scooter – Cash Flows
Year 0 Year 1-10
Investment 15.00
1. Revenue 37.50
2. Variable cost 12.00
3. Fixed cost 19.00
4. Depreciation 1.50
5. Pretax profit (1-2-3-4) 5.00
6.Tax 2.50
7. Net profit (5-6) 2.50
8. Operating cash flow (4+7) 4.00

Net cash flow (15.00) 4.00

 Break Even Analysis
• Point at which the NPV=0 is the break even point
• Otobai Motors has a breakeven point of 85,000 units
sold. PV Inflows

Break even
400 NPV=0
PV (Yen)
Billions PV Outflows
200

19.6
Sales, 000’s
85 200
 Break Even Analysis
• Accounting break even is different, yet wrong. It does not
consider the time value of money.
• Otobai Motors has an accounting breakeven point of 60,000
60 Revenues
units sold.
Break even

40 Profit =0
Accounting
revenue and
costs (Yen) Costs
20
Billions

Sales, 000’s
60 200
 Difference – Accounting vs Cashflow
• Accounting profit breakeven at 60,000 units
• Cashflow breakeven at 85,000 units
• While 60,000 units will recover the initial
outlay of 15bn, it is not sufficient to recover
the opportunity cost of the capital used.
• The break even point will always be higher for
cash flows than for accounting profits due to
depreciation and the cost of capital.
 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 in profits

% change in sales

or
fixed costs
DOL  1 
profits
 Operating Leverage
Example – Use the data from the Otobai scooter project.What is
the DOL?

(3  1.5)
DOL = 1   2.5
3
 Monte Carlo Simulation
Modeling Process
• Step 1: Modeling the Project
• Step 2: Specifying Probabilities
• Step 3: Simulate the Cash Flows
• Step 4: Calculate Present Value
Monte Carlo Simulation
 Flexibility & Real 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.
 Decision Trees
Example - FedEx Expansion Option

Exercise
High delivery
Demand option
Observe
growth in
demand for
airfreight

Acquire option on Don’t

Low
future delivery take
Demand
delivery
 Real Options
1. Option to expand
2. Option to abandon
3. Timing option
4. Flexible production facilities
 Decision Trees
$700 (.80)
- $130

.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130

Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130

$ 0 (.20)
 Decision Trees
$700 (.80)
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80

$ 0 (.20)
 Decision Trees
$700 (.80)
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130

700 .80  0 .20  560

80

$ 0 (.20)
 Decision Trees
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
560
- $18 .44 .50  130
NPV (upside) 
- $130  295
1.0963
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80

$ 0 (.20)
 Decision Trees
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80
NPV = - $69
(do not invest, so NPV = 0)
$ 0 (.20)
 Decision Trees
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25 (0  .25)  (52  .5)  (295  .25)
NPV  $2 100 (.80)
NPV= ? - $130 1.096
NPV = - $69  $83
80
(do not invest, so NPV = 0)
$ 0 (.20)
 Decision Trees
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= $19 NPV  18  (.-44  83)  (.56  0)
$130
NPV =-$$69
19 80
(do not invest, so NPV = 0)
$ 0 (.20)
 Decision Trees
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= $19 - $130
80
NPV = - $69
(do not invest, so NPV = 0)
$ 0 (.20)