Chapter 11

Project Analysis and Evaluation

9-1
Evaluating NPV Estimates
The basic problem: How reliable is our NPV estimate?

• Projected cash flows are based on a distribution of possible

outcomes each period: resulting in an ‘average’ cash flow.

• Forecasting risk: the possibility of an incorrect decision due to

errors in cash flow projections.

• Xbox vs PlayStation case (fewer games made for the Xbox)

• Market research?

9-2
Scenario and Other ‘What If’ Analysis
• Base case estimation
– Estimated NPV based on initial cash flow projections.

• Scenario analysis
– Examine effect on NPV of best-case and worst-case
scenarios.

• Sensitivity analysis
– Examine effect on NPV by changing only one input
variable.

• Simulation analysis
– Vary several input variables simultaneously to construct a
distribution of possible NPV estimates.

9-3
 Comparison

• With scenario analysis, we let all the different

variables change, but we let them take on only a
few values.

• With sensitivity analysis, we let only one variable

change, but we let it take on many values.

• If we combine the two approaches, the result is a

crude form of simulation analysis.

9-4
Fairways Driving Range Example

Fairways park expects annual visitors to be 20 000 at $3 per

visit. Total capital costs $20 000 and is depreciated using the
straight-line method over five years to a zero salvage value.
Variable costs are 10 per cent of park visit income and fixed
costs are $40 000 per year. Assume no increase in working
capital and no additional capital outlays. The required rate of
return is 15 per cent and the tax rate is 30 per cent.

9-5
Fairways Example—Net Profit

9-6
Fairways Example—Base Case NPV
• Estimated operating cash flow:
$10 000 + $4000 – $3000 = $11 000

• At 15%, the 5-year annuity factor is 3.3522.

• The base case NPV is then:

NPV = – $20 000 + ($11 000 × 3.3522)

= $16 874

9-7
Fairways Example—Scenario
Analysis
Inputs for scenario analysis:
Base case: Park visits are 20 000 p.a., variable costs are
10 per cent of park visit income, fixed costs are $40 000,
depreciation is $4000 p.a.

Best case: Park visits are 25 000 buckets p.a., variable

costs are 8 per cent of park visit income, fixed costs are
$40 000, depreciation is $4000 p.a.

Worst case: Park visits are 18 000 buckets p.a., variable

costs are 12 per cent of park income, fixed costs are
$40 000, depreciation is $4000 p.a.

9-8
Fairways Example—Scenario Analysis

9-9
Fairways Example—Sensitivity
Analysis

Inputs for sensitivity analysis:

Base case: Park visits are 20 000 p.a., variable costs are 10
per cent of income, fixed costs are $40 000, depreciation is
$4000 p.a.

Best case: Park visits are 25 000 p.a. All other variables are
unchanged.

Worst case: Park visits are 18 000 p.a. All other variables are
unchanged.

9-10
Fairways Example—Sensitivity
Analysis

9-11
Break-even Analysis
• Useful for analysing the relationship between sales volume
and profitability.

• Break-even point is the sales volume at which the present

value of the project’s cash inflows and outflows are equal →
NPV = 0.

• Important distinction between variable costs and fixed costs.

• Accounting break-even is the sales volume that results in a

zero net profit.

9-12
Fixed and Variable Costs
• There are two types of costs that are important in break-even
analysis: variable and fixed.
-Variable costs change when the quantity of output changes
-Total variable costs= quantity × cost per unit
-Fixed costs are constant, regardless of output, over some
time period
-Total Costs = fixed + variable = FC + vQ

Example:
Your firm pays $3000 per month in fixed costs. You also pay $15
per unit to produce your product.

(Total cost if you produce 1000 units = 3000 + 15(1000) = 18 000)

(Total cost if you produce 5000 units = 3000 + 15(5000) = 78 000)

9-13
Using Accounting Break-even
• Accounting break-even is often used as an early-
stage screening number.

• If a project cannot break even on an accounting

basis, then it is not going to be a worthwhile
project.

• Accounting break-even gives managers an

indication of how a project will impact accounting
profit.

9-14
Accounting of Break-even Point

General expression

Q = (FC + D)/(P – v)
where:
Q = total units sold
FC = total fixed costs
D = depreciation
P = price per unit
v = variable cost per unit

9-15
Fairways Example—Accounting
Break-even Analysis

9-16
Fairways Example—Accounting
Break-even Analysis
Solve algebraically for break-even quantity (Q):

9-17
 Other Break-even Measures

• Cash break-even
– Q = FC/(p – v)

9-18
Operating Leverage
• The degree to which a firm is committed to its fixed costs.
• The higher the degree of operating leverage, the greater the
danger from forecasting risk.
• The lower the degree of operating leverage, the lower the
break-even point.

• DOL depends on the current sales level.

9-19
Fairways Example—DOL

• Let Q = 20 000 visitors and, ignoring taxes, OCF = $14 000

and FC = $40 000.

• A 10 per cent increase (decrease) in quantity sold will result

in a 38.57 per cent increase (decrease) in OCF.
• Note: Higher DOL equals greater volatility (risk) in OCF and
leverage is a two-edged sword—sales decreases will be
magnified as much as increases.
• Airlines industry example

9-20