Chapter 10

PROJECT ANALYSIS

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
10-1 THE CAPITAL INVESTMENT PROCESS
• Capital Budget
• List of investment projects under consideration
by a firm
• Do not add fudge factors to cost of capital

• Postaudit
• Review of project to see if met forecasts

10-2
10-2
10-2 SENSITIVITY ANALYSIS
• Types of Analysis
• Sensitivity
• Analyzes effects of changes in sales, costs, etc., on project
• Scenario
• Project analysis given particular combination of
assumptions
• Simulation
• Estimates probabilities of different outcomes
• Break Even
• Level of sales (or other variable) at which project breaks
even

10-3
10-3
10-2 SENSITIVITY ANALYSIS
• Example
• Given expected cash-flow forecasts for Otobai
Company’s Motor Scooter project, determine
the NPV of project given changes in cash- flow
components using 10% cost of capital. Assume
constant variables, except the one you are
changing.

10-4
10-4
10-2 SENSITIVITY ANALYSIS
• Example, continued
Year 0 Years 1 - 10
Investment - 15
Sales 37.5
Variable costs 30
Fixed costs 3
Depreciation 1.5
Pretax profit 3.0
Taxes @ 50% 1.5
Profit after tax 1.5
Operating cash flow 3.0
Net Cash Flow - 15 3

10-5
10-5
10-2 SENSITIVITY ANALYSIS
• Example, continued

Outcomes
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

10-6
10-6
10-2 SENSITIVITY ANALYSIS
• Example, continued
• NPV calculations—Optimistic 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
Operating cash flow 3.38
Net Cash Flow - 15  3.38
10-7
10-7
10-2 SENSITIVITY ANALYSIS
• Example, continued

Possibilities ( Billions ¥)
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

10-8
10-8
TABLE 10.3 NPV OF ELECTRIC SCOOTER

10-9
10-9
TABLE 10.3 ELECTRIC SCOOTER ASSUMPTIONS

10-10
10-10
TABLE 10.4 ELECTRIC SCOOTER
SCENARIOS

10-11
10-11
TABLE 10.5 ELECTRIC SCOOTER ACCOUNTING
PROFIT

10-12
10-12
TABLE 10.1 ELECTRIC SCOOTER CASH-FLOW
FORECASTS

10-13
10-13
FIGURE 10.1 BREAK-EVEN CHART
• Point at which NPV=0 is break-even point
• Otobai Motors has a break-even point of 85,000
units sold
PV (Yen) PV inflows
Billions
Break-even
400 NPV = 0

200 PV Outflows

19.6

85 200 Sales, thousands

10-14
10-14
FIGURE 10.2 ACCOUNTING BREAK-EVEN
• Accounting break-even does not consider time
value of money
• Otobai Motors has accounting break-even point
of 60,000 units sold
60 Revenues

Accounting Break -even

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

Sales, thousands
60 200 10-15
10-15
10-2 SENSITIVITY ANALYSIS
• Operating Leverage
• Degree to which costs are fixed

• Degree of Operating Leverage (DOL)

• Percentage change in profits given 1% change
in sales
% change in profits
DOL  % change in sales

or
fixed costs
DOL  1 
profits
10-16
10-16
10-2 SENSITIVITY ANALYSIS
• Example
• Using the data from the Otobai scooter project,
calculate the DOL

(3  1.5)
DOL = 1   2.5
3

10-17
10-17
10-3 MONTE CARLO SIMULATION
• Modeling Process
• Step 1: Model Project
• Step 2: Specify Probabilities
• Step 3: Simulate Cash Flows
• Step 4: Calculate Present Value

10-18
10-18
FIGURE 10.3 SIMULATION OF CASH
FLOWS

10-19
10-19
10-4 REAL OPTIONS AND DECISION TREES
• Decision Trees
• Diagram of sequential decisions and possible
outcomes
• Help companies analyze options by showing
various choices and outcomes
• Option to avoid a loss or produce extra profit
has value
• Ability to create option has value that can be
bought or sold

10-20
10-20
FIGURE 10.4 FEDEX’S EXPANSION OPTION

10-21
10-21
FIGURE 10.4 FEDEX’S EXPANSION OPTION
• Real Options
• Option to expand
• Option to abandon
• Timing option
• Flexible production facilities

10-22
10-22
FIGURE 10.6 DECISION TREE
$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)
10-23
10-23
FIGURE 10.6 DECISION TREE
$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)
10-24
10-24
FIGURE 10.6 DECISION TREE
$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)
10-25
10-25
FIGURE 10.6 DECISION TREE
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
560
- $18 NPV (upside)
.44 .50  130 
- $130  295
1.0963
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80

$ 0 (.20)
10-26
10-26
FIGURE 10.6 DECISION TREE
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
Invest .56 NPV = $52
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80
NPV = - $69
(do not invest, so NPV =
$ 0 (.20)
0)
10-27
10-27
FIGURE 10.6 DECISION TREE
$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
80
NPV = - $69  $83
(do not invest, so NPV =
$ 0 (.20)
0)
10-28
10-28
FIGURE 10.6 DECISION TREE
$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
 $19 80
NPV = - $69
(do not invest, so NPV =
$ 0 (.20)
0)
10-29
10-29
FIGURE 10.6 DECISION TREE
$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 (.20)
0)
10-30
10-30