Financial Management:: Risk Analysis and Project Evaluation

Financial Management:
Principles & Applications

Thirteenth Edition, Global Edition
Chapter 13
Risk Analysis and
Project Evaluation
Copyright © 2018 Pearson Education, Ltd. Education,

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Ltd. All Reserved
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Learning Objectives
1. Explain the importance of risk analysis in the
capital-budgeting decision-making process.
2. Use sensitivity, scenario and simulation analyses
to investigate the determinants of project cash
flows.
3. Use break-even analysis to evaluate project risk.
4. Describe the types of real options.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Principles Applied in This Chapter
• Principle 1: Money has a Time Value
• Principle 2: There Is a Risk-Return Tradeoff
• Principle 3:Cash Flows are the Source of Value

13.1 THE IMPORTANCE OF RISK ANALYSIS

The Importance of Risk Analysis
There are two fundamental reasons to perform a
project risk analysis before making the final
accept/reject decision:
– Project cash flows are risky and may not be equal to
the estimates of future cash flows used to compute
NPV.
– Forecasts are made by humans who can be either too
optimistic or too pessimistic when making their cash
flow forecasts.

13.2 TOOLS FOR ANALYZING THE RISK
OF PROJECT CASH FLOWS

Tools for Analyzing the Risk of Project
Cash Flows
The actual cash flows an investment produces will
almost never exactly equal the expected cash flows
used to estimate the investment’s NPV. There are
many possible cash flow outcomes for any risky
project. The analyst uses tools such as Sensitivity
analysis, Scenario analysis, and Simulation analysis
to examine the uncertainty of future cash flows and
better understand the reliability of the NPV
estimate.

Key Concepts—Expected Values and
Value Drivers (1 of 3)
The cash flows used in the calculation of a project’s
NPV are actually the expected values of the
investment’s risky cash flows. The expected value
of a future cash flow is simply a probability-weighted
average of all the possible cash flows that might
occur.

Example What is the expected cash value if there
are two possible cash flows, $100 and $400 and the
probabilities of these cash flows are 25% and 75%.
Expected cash value = .25 (100) + .75 (400)
= $325

• Financial managers sometimes refer to the basic
determinants of an investment’s cash flows – and
consequently, its performance – as value drivers.
• Value drivers for investment cash flows consist of
fundamental determinants of project revenues
(e.g., market size, market share, and unit price)
and costs (e.g., variable costs and cash fixed
costs, which exclude depreciation expense)

CHECKPOINT 13.1: CHECK YOURSELF
Forecasting Revenues Using Expected Values

The Problem
Consider your forecast of Marshall Home’s
expected revenues for 2014 where the probability of
entering a deep recession increases to 40%, the
probability of mild recession drops to 50%, and the
probability of a turn-around declines to only 10%.
You may assume that the estimates of the number
of units sold and the selling price of each remain
unchanged.

Step 1: Picture the Problem (1 of 2)
The following table lays out the number of units the
firm’s manager estimate they will sell in each of
three home categories for each of the three
possible states of the economy:

Blank Deep Recession Mild Recession Turn-Around
Probability 40% 50% 10%

High Priced Home: $0 $40,000,000 $80,000,000
Total Revenues
Medium Priced Home: $20,000,000 $60,000,000 $120,000,000

Total Revenues
Low-Priced Home: $20,000,000 $40,000,000 $120,000,000

Total Revenues
Blank Blank Blank Blank

Total Revenues for each Scenario $40,000,000 $140,000,000 $320,000,000

Step 2: Decide on a Solution Strategy
To compute the expected total revenue, we can
proceed in three steps:
1. Estimate the probability of each state of the
economy.
2. Calculate the total revenue from each
category of homes for each of the three states
of the economy.
3. Calculate a probability weighted average of
the total revenues (step 2 times step 3).

Step 3: Solve
Blank Blank Deep Recession Mild Recession Turn-around
Step 1 Probability 40% 50% 10%
Step 2 Total Revenues for each $40,000,000 $140,000,000 $320,000,000

Scenario
Step 3 Probability × Total Revenue $16,000,000 $70,000,000 $32,000,000
The expected total revenues declines from

$156,000,000 to $118,0000.

Step 4: Analyze
The table in step 3 shows that there can be wide
variation in revenue based on the future economic
scenario. The table only shows the revenues. To get
a more realistic picture, we should also consider the
impact on expenses and consequently, profits and
cash flows.

Sensitivity Analysis
Sensitivity analysis occurs when a financial
manager evaluates the effect of each value driver
on the investment’s NPV. It helps identify the
variable that has the most impact on NPV.

Project Risk Analysis: Sensitivity Analysis

The Problem
Cranium’s management has determined that it will
be possible to reduce the variable cost per unit
down to $18 per unit by purchasing an additional
option for the equipment that will raise its initial cost
to $1.8 million (the residual or salvage value for this
configuration is estimated to be $300,000). All other
information remains the same as before. For this
new machinery configuration, analyze the sensitivity
of the project NPV.

To evaluate the sensitivity of the project’s NPV and
IRR to uncertainty surrounding the project’s value
drivers, we need to analyze the effects of the
changes in the value drivers (unit sales, price per
unit, variable cost per unit, and annual fixed
operating cost other than depreciation).

We consider the following changes:
– Unit sales (−10%)
– Price per unit (−10%)
– Variable cost per unit (+10%)
– Cash fixed costs per year (+10%)

• The objective of this analysis is to explore the
effects of the prescribed changes in the value
drivers on the project’s NPV.
• We will need to estimate the base-case NPV
based on given information and then compute the
NPV based on assumed changes to the value
drivers.

Step 3: Solve (1 of 3)
• Following are the projected cash flows for years 0-5:
Blank Year-0 Years 1-4 Year-5
Revenues Blank 5,000,000 5,000,000
Less: Variable cost Blank $ (3,600,000.00) $ (3,600,000.00)
Less: Depreciation expense Blank $ (300,000.00) $ (300,000.00)
Less: Cash fixed cost Blank $ (400,000.00) $ (400,000.00)

Net operating income Blank $ 700,000.00 $ 700,000.00
Less: Taxes Blank $ (210,000.00) $ (210,000.00)

Net operating profit after tax Blank $ 490,000.00 $ 490,000.00
plus: Depreciation expense Blank $ 300,000.00 $ 300,000.00
less: CAPEX $ (1,800,000.00)Blank $ 300,000.00

less: change in working capital $ (500,000.00) Blank $ 500,000.00
Free cash flow $ (2,300,000.00) $ 790,000.00 $ 1,590,000.00

Given the free cash flows for years 0-5, we can compute the
NPV and IRR on Excel spreadsheet, which gives us the
following results:
Year Free Cash Flow

0 $ (2,300,000.00)
1 $ 790,000.00
2 $ 790,000.00
3 $ 790,000.00
4 $ 790,000.00
5 $ 1,590,000.00
NPV $1,001,714.68
IRR 26.65%

The following table shows the impact on NPV of changes in
the value drivers.
Value Drivers Expected NPV Revised NPV % Change
Unit Sales (−10%) $1,001,714.68 $ 648,446.62 −35%
Price per unit (−10%) $1,001,714.68 $ (259,956.99) −126%
Variable cost (+10%) $1,001,714.68 $ 220,414.70 −78%
Cash fixed cost (+10%) $1,001,714.68 $ 900,780.95 −10%

Step 4: Analyze (1 of 2)
Here we observe that a 10% adverse change in
value drivers has a significant impact on NPV. If the
price per unit drops by 10%, the project turns
negative with the value of NPV declining by 126%.

Step 4: Analyze (2 of 2)
The results also show that NPV is most sensitive to
changes in the selling price and variable cost. Thus
management must be doubly sure that the
estimates on these value drivers are accurate and
that these two value drivers are closely monitored.

Scenario Analysis
Sensitivity analysis involves changing one value
driver at a time and analyzing its effect on the
investment NPV. Scenario analysis allows the
financial manager to simultaneously consider the
effects of changes in the estimates of multiple value
drivers on the investment opportunity’s NPV.

Project Risk Analysis: Scenario Analysis

The Problem
The deepening recession that characterized the
economy caused Cranium’s management to
reconsider the base-case scenario for the project by
lowering their unit sales estimates to 175,000 at
revised price per unit of $24.50. Based on these
projections, is the project still viable? What if
Longhorn followed a higher price strategy of $35
per unit but only sold 100,000 units? What would
you recommend Longhorn do?

Step 1: Picture the Problem
• We are given the following revised estimates for
two scenarios:
Blank Scenario 1 Scenario 2
Unit sales 175,000.00 100,000.00
Price per unit $24.50 $35
• Rest of the information is the same as Checkpoint

13.2

Our objective is to determine the sensitivity of NPV
to the two scenarios. We can estimate the free cash
flows as before and then compute the NPVs for the
two scenarios and compare.

Scenario 1 cash flow and NPV/IRR estimates
Blank Year 0 Years 1-4 Year-5
Revenues Blank $ 4,287,500.00 $ 4,287,500.00

Less: Taxes Blank $ (41,250.00) $ (41,250.00)
less: CAPEX $ (1,500,000.00) Blank $ 250,000.00

Free cash flow $ (2,000,000.00) $ 346,250.00 $ 1,096,250.00
NPV ($326,276.10)
IRR 6.29%
Scenario 2 cash flow and NPV/IRR estimates
Blank Year 0 Years 1-4 Year-5
Revenues Blank $ 3,500,000.00 $ 3,500,000.00

Less: Taxes Blank $ (255,000.00) $ (255,000.00)
less: CAPEX $ (1,500,000.00) Blank $ 250,000.00

Free cash flow $ (2,000,000.00) $ 845,000.00 $ 1,595,000.00
NPV = $1,471,606
IRR = 36%
Step 4: Analyze
Examination of the two scenarios reveals that this is
a risky opportunity as there is a wide divergence in
the NPV estimates. The NPV could be as high as
$1,491,606 or as low as a negative $326,276.

Simulation Analysis (1 of 3)
Scenario analysis provides the analyst with a
discrete number of project NPV estimates for a
limited number of cases or scenarios. Simulation
analysis generates thousands of NPV estimates
that are built on thousands of values for each of the
investment’s value drivers. These different values
arise out of each value driver’s individual probability
distribution.

• Simulation process involves the following five steps:
1. Select appropriate probability distribution for each
of the investment’s key value drivers.
2. Randomly select one value for each of the value
drivers from its respective probability
distributions.
3. Combine the values selected for each of the
values drivers to estimate project cash flows for
each year of the project’s life, and calculate the
project’s NPV.

4. Store or save the calculated value of the NPV,
and repeat Steps 2 and 3. Computer softwares
allows one to easily repeat Steps 2 and 3
thousands of times.
5. Use the stored values of the project NPV to
construct a histogram or probability distribution of
NPV.

Figure 13-1 Probability Distribution of NPVs for the
Marketing of Longhorn’s Brake Lights

13.3 BREAK—EVEN ANALYSIS

Break—Even Analysis
Break-even analysis determines the minimum level
of output or sales that the firm must achieve in order
to avoid losing money – that is, to break even. In
most cases, break-even sales is defined as the
level of sales for which net operating income (NOI)
equals zero.

Accounting Break—Even Analysis
• Accounting break-even analysis involves
determining the level of sales necessary to cover
total fixed costs – that is, both cash fixed costs
and depreciation.
• We decompose production costs into two
components: fixed costs and variable costs.

Fixed Costs
• Fixed costs (or indirect costs) do not vary
directly with sales revenue but instead remain
constant despite any change to the business; they
can be divided into fixed operating costs before
depreciation and depreciation itself.
• As the number of units sold increases, fixed cost
per unit decreases, because the fixed costs are
spread over larger quantities of output.

Variable Costs
• Variable costs (or direct costs) are those costs
that vary with firm sales. For example, hourly
wages, cost of materials used, sales commission.
• Variable costs per unit remain the same
regardless of the level of output. If zero units are
produced, total variable costs will be equal to
zero.

Calculating the Accounting Break—Even
Point
The accounting break-even point is the level of
sales that is necessary to cover both variable and
total fixed costs, such that the net operating income
is equal to zero.
Total Fixed Costs (F ) Total Fixed Costs (F )
QAccounting break-even  
Price per Variable Cost Contribution Margin

Unit (P ) per Unit (V ) per Unit

Figure 13-2 Accounting Break—Even Analysis (1 of 2)

Figure 13-2 Accounting Break—Even Analysis (2 of 2)

Project Risk Analysis:
Accounting Break-Even Analysis

The Problem
Crainium, Inc.’s analysts have estimated the
accounting break-even for the project to be 130,000
units and now want to consider how the values for
the worst-case scenario affect the accounting
break-even. Specifically, consider a unit price of
$23, variable cost per unit of $21, and total fixed
costs of $700,000.

The new investment that Crainium, Inc. is planning
to invest is described in Checkpoint 13.2 with the
following revised estimates:
– Price per unit = $25
– Variable cost per unit = $23
– Total fixed cost per year = $700,000

The annual costs consists of total fixed costs and
variable costs that vary by the level of output.
Total costs
= Variable cost (# of units) + Total fixed costs

The following table shows the break-up of total costs for four units of
output.
Units of Output Variable Costs Fixed Costs Total Costs

50,000.00 $ 1,050,000.00 $700,000.00 $ 1,750,000.00
100,000.00 $ 2,100,000.00 $700,000.00 $ 2,800,000.00
150,000.00 $ 3,150,000.00 $700,000.00 $ 3,850,000.00
200,000.00 $ 4,200,000.00 $700,000.00 $ 4,900,000.00

To determine the accounting breakeven quantity, we
can use the following equation:
QBreak-even = F ÷ (P−V)
– Where F = total fixed costs
P = Sale price per unit
V = Variable cost per unit

QBreak-even = F ÷ (P−V)
= $700,000 ÷ ($23−$21)
= $700,000 ÷ $2
= 350,000 units

The table below shows that at 350,000 units of output, total
costs = total revenue i.e. the firm breaks even or accounting
profits are equal to zero.
Units of Output Variable Costs Fixed Costs Total Costs Revenue Profit
50,000.00 $ 1,050,000.00 $700,000.00 $1,750,000.00 1,150,000.00 (600,000.00)
100,000.00 $ 2,100,000.00 $700,000.00 $2,800,000.00 2,300,000.00 (500,000.00)
150,000.00 $ 3,150,000.00 $700,000.00 $3,850,000.00 3,450,000.00 (400,000.00)
200,000.00 $ 4,200,000.00 $700,000.00 $4,900,000.00 4,600,000.00 (300,000.00)
350,000.00 $ 7,350,000.00 $700,000.00 $8,050,000.00 8,050,000.00 $0

Step 4: Analyze
Break-even point sets the lower limit on the level of
sales, from an accounting perspective. Note
projects that merely break even in an accounting
sense have negative NPVs and results in a loss of
shareholder value.

Cash Break—Even Analysis
The cash break-even point tells us the level of
sales where we have covered our cash fixed costs
(ignoring depreciation) and as a result, our cash
flow is zero.
Total Fixed Costs (F )  Depreciation


Contribution Margin
per Unit

NPV Break—Even Analysis
The NPV break-even analysis identifies the level
of sales necessary to produce an NPV of zero. It
differs from accounting break-even analysis in that
NPV break-even focuses on cash flows, not
accounting profits, and also accounts for Principle
1: Money Has a Time Value.

Figure 13-3 NPV Break—Even
Blank Worst-Case Scenario
Price per unit $ 190
Variable cost per unit $ (160)
Cash fixed costs per year $(285,000)

Operating Leverage and the Volatility of
Project Cash Flows (1 of 3)
• The composition of fixed and variable costs vary
by firm. The mix of fixed and variable operating
costs not only affects the break-even output but
also determines the operating leverage.
• Operating leverage, which tends to be higher for
firms with more fixed costs, measures the
sensitivity of changes in operating income to
changes in sales.

• Degree of operating leverage (DOL) tells us
when there is a percent change in sales, how that
is reflected in a percent change in NOI. Thus, if
DOL is 3.0 and there is a 5% change in sales, NOI
will increase by 15% (3.0 × 5%)
% Change in Net Operating Income (NOI )

DOL 
% Change in Sales

Table 13-1 How Operating Leverage Affects NOI for a 20%
Increase in Longhorn’s Sales
Blank Base Sales Level for Forecast Sales Percentage Change in Sales
Year t Level for Year t and NOI
+1
Unit sales 15,000 18,000 Blank
Sales $3,000,000 $3,600,000 +20% = $3.6 million/$3.0

million − 1
Less: Total variable costs 2,250,000 2,700,000 Blank
Revenue before fixed costs $ 750,000 $ 900,000 Blank
Less: Total fixed costs 375,000 375,000 Blank
NOI (or EBIT) $ 375,000 $ 525,000 +40% = $525,000/$375,000 −

1

Table 13-2 How Operating Leverage Affects NOI for a 20%
Decrease in Longhorn’s Sales
Blank Base Sales Forecast Sales Percentage Change in

Level for Year t Level for Year t +1 Sales and NOI
Unit sales 15,000 12,000 Blank
Sales $3,000,000 $2,400,000 −20% = $2.4 million/$3.0

million − 1
Less: Total variable costs 2,250,000 1,800,000 Blank
Revenue before fixed costs $ 750,000 $ 600,000 Blank
Less: Total fixed costs 375,000 375,000 Blank
NOI or (EBIT) $ 375,000 $ 225,000 −40% =

$225,000/$375,000 − 1

We can summarize operating leverage as follows:
– Operating leverage is higher if fixed operating costs are
high relative to variable operating costs.
– Higher operating costs increases the sensitivity of
operating income to changes in sales.
– DOL is an indication of the firm’s use of operating
leverage. The DOL is not a constant but decreases as
the level of sales increase beyond break-even point.
– Operating leverage is a double-edged sword; it
magnifies both profits and losses, helping in good times
and causing pain in the bad times.
13.4 REAL OPTIONS IN CAPITAL BUDGETING

Real Options in Capital Budgeting (1 of 2)
Opportunities to alter the project’s cash flow stream
after the project has begun are referred to as real
options. The most common sources of flexibility or
real options that can add value to an investment
opportunity include:
1. Timing Options - the option to delay a project
until estimated future cash flows are more
favorable.

Real Options in Capital Budgeting (2 of 2)
2. Expansion Options - the option to increase
the scale and scope of an investment in
response to realized demand; and
3. Contract, Shut-down, and Abandonment
options - the options to slow down
production, halt production temporarily, or
stop production permanently (abandonment).

Analyzing Real Options:
Option to Expand

The Problem
If you thought there was a 40% chance that this
project would be favorably received and 60%
chance that the project would be unfavorably
received, what would be the NPV of the project if
you were to introduce 10 additional restaurants if it
is well received?

Step 1: Picture the Problem
Build 1 smooth-Thru at a
P(favorable)
cost of $2.4 million

= .4
Build 10 more Don’t build any more

restaurants restaurants
NPV = 10 × $800,000
P(Unfavorable)
= .6 NPV = −$1,600,000

We need to determine the NPV of this project
assuming we will build 10 restaurants if the project
is favorably received and will not build any
additional restaurants if it is not favorably received.

We are given the following information (per
Restaurant):
• Perpetual annual cash flow:
– if favorably received = $320,000
– if not favorably received = $80,000
• Probability of being favorably received = 40%
• Discount rate = 10%

We use the PV of perpetuity equation (given by
CF/i) to determine the present value of cash flows.
• NPV (if favorably received)
– = ($320,000 ÷.10) − $2,400,000 = $800,000
• NPV (if not favorably received)
– = ($80,000 ÷.10) − $2,400,000 = −$1,600,000

• Assuming we will open 10 restaurants if it is
favorably received and only one if it is unfavorably
received, we can determine the expected NPV as
follows:
• Expected NPV
= 10 (.4)($800,000) + 1(.60)(−1,600,000)
= $2,240,000

Step 4: Analyze
Without the option to expand, this project would
have had a NPV of −$640,000.
NPV = $800,000(.4) + (−$1,600,000)(.6)
= −$640,000
However, by considering the option to expand, the
project has a positive NPV.

Key Terms (1 of 3)
• Accounting break-even analysis
• Break-even analysis
• Cash break-even point
• Contribution margin
• Degree of operating leverage (DOL)
• Direct cost
• Expected value

Key Terms (2 of 3)
• Fixed cost
• Indirect cost
• NPV break-even analysis
• Operating leverage
• Real options
• Scenario analysis
• Sensitivity analysis

Key Terms (3 of 3)
• Simulation analysis
• Value drivers
• Variable costs

Financial Management:: Risk Analysis and Project Evaluation

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Financial Management:

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Probability 40% 50% 10%

Medium Priced Home: $20,000,000 $60,000,000 $120,000,000

Low-Priced Home: $20,000,000 $40,000,000 $120,000,000

Blank Blank Blank Blank

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Step 1 Probability 40% 50% 10%

Step 2 Total Revenues for each $40,000,000 $140,000,000 $320,000,000

The expected total revenues declines from

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Less: Cash fixed cost Blank $ (400,000.00) $ (400,000.00)

Less: Taxes Blank $ (210,000.00) $ (210,000.00)

plus: Depreciation expense Blank $ 300,000.00 $ 300,000.00

less: CAPEX $ (1,800,000.00)Blank $ 300,000.00

Free cash flow $ (2,300,000.00) $ 790,000.00 $ 1,590,000.00

Year Free Cash Flow

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Value Drivers Expected NPV Revised NPV % Change

Unit Sales (−10%) $1,001,714.68 $ 648,446.62 −35%

Price per unit (−10%) $1,001,714.68 $ (259,956.99) −126%

Variable cost (+10%) $1,001,714.68 $ 220,414.70 −78%

Cash fixed cost (+10%) $1,001,714.68 $ 900,780.95 −10%

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Unit sales 175,000.00 100,000.00

Price per unit $24.50 $35

• Rest of the information is the same as Checkpoint

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Less: Cash fixed cost Blank $ (400,000.00) $ (400,000.00)

plus: Depreciation expense Blank $ 250,000.00 $ 250,000.00

less: CAPEX $ (1,500,000.00) Blank $ 250,000.00

Free cash flow $ (2,000,000.00) $ 346,250.00 $ 1,096,250.00

Less: Cash fixed cost Blank $ (400,000.00) $ (400,000.00)

plus: Depreciation expense Blank $ 250,000.00 $ 250,000.00

less: CAPEX $ (1,500,000.00) Blank $ 250,000.00

Free cash flow $ (2,000,000.00) $ 845,000.00 $ 1,595,000.00