Chapter 11 (Project Analysis and Evaluation)

OCF

(revenue-variable costs)*quantity of output -fixed costs

break even output calculation

Q (output) = (fixed costs +operating cash flow)/(revenue-variable costs)

hard rationing

a business cannot raise capital for a project under any circumstances does not happen for large healthy corps very often DCF breaks down, best course of action becomes ambiguous; required return becomes ambiguous because cannot take a new project no matter what return is can occur if financial distress with bankruptcy as possibility, or cannot do or in breach of contract

scenario analysis

basic form of what if analysis investigate changes in npv estimates that result from asking questions about values used in calculation (good estimate if most plausible scenarios results in positive npv) often start w worst case to tell min npv and best case max npv (or optimistic/pessimistic cases) around 5 cases suggested to consider (best, worst, base, and intermediates)

simulation analysis

combination of scenario/sensitivity analyses use computer, let all items vary at same time; probably get thousands of possible npvs; summarize these by avg value and measure of spread no simple decision rule, determining probabilities of different scenarios difficult rare in practice; new computer hardware/software may mean it becomes more common

variable costs

costs that change as quantity of output changes, zero when production is zero direct labor costs, raw material costs assume they are constant amount per unit of outputt

fixed costs

costs that do not change during specified time period lease payment, president's salary not fixed forever! effectively sunk cost, will have to pay no matter what

soft rationinig

different units in a business are allocated some fixed amount of money each year for capital spending; means of controlling/keeping track of overall spending corporation as a whole isn't short on capital; more can be raised if management desires what to do: 1. try to get larger allocation 2. generate large npv as possible within existing budget (choose projects w largest profitability index)

forecasting risk

estimation risk possibility that we will make bas decision because of errors in projected cash flows (think NPV is positive when it is not)

capital rationing

exists when profitable investments available but can't get funds to undertake them; limited spending can be soft or hard

sources of value

first line of defense against forecasting risk; what about this project leads to positive npv? where does it gain this value from? keep in mind market competition; positive npv rare in highly competitive environment -also potential competition (will other firms try to do same thing?)

paralysis of analysis

generate more possibilities no matter how many scenarios run, all we can learn are possibilities, some are good and some are bad; no other guidance will be achieved by running more

degree of operating leverage

if quantity sold rises by x percent, what will be percentage change in operating cash flow? percent change in ocf = DOL * percentage change in output DOL= 1 + fixed costs/operating cash flow with zero fixed costs, no magnification/leverage exists operating leverage declines at output rises easier to increase OL than decrease it

base case

initial set of projections for cash flows

upper/lower bounds

method of organizing investigation into npv accuracy set upper/lower bounds on components of project that are estimated (unlikely true average will be outside of range given)

accounting break-even

most widely used measure of break even sales level that results in zero project net income includes depreciation in expenses why use? quick and easy to calculate, if the sales required are unlikely questions if npv is actually likely to be negative easy/simple to explain manager's concerned w contribution project will make to firm's total accounting earnings project breaking even in accounting sense loses money financially/opportunity costs

the basic problem

now we know NPV is positive; this could either be accurate, or could be because our estimate is off

cash break even

particularly unpleasant occurrence for cash flow to go negative plug in OCF is 0, output = fixed costs/(revenue-variable costs)

break even analysis

popular, commonly used tool for analyzing relationship bw sales volume and profitabiliity ex; payback period

projected vs. actual cash flows

projected cash flows often inaccurate; would be surprised if it turned out to be exactly correct took all cash flows over length, averaged, result would be projected cash flow; expect averages to be correct

capital intensive

projects with heavy investment in plant/equipment (high fixed costs) have high operating leverage

financial break even

sales level that results in zero npv first determine what ocf must be for npv to be zero, then determine output substantially higher than accounting break even usually

what is frequently a crucial variable for project?

sales volume hardest to forecast accurately how much we can sell

implications of operating leverage

small change in operating revenue can be magnified to large change in ocf and npv higher leverage, greater potential for forecasting risk (small errors in sales volume get magnified) managers want to keep operating leverage levels low (keep break even point at minimum level)

total clost

sum of variable costs and fixed costs for given level of output relationship bw quantities produced and total costs is straight line, increasing

marginal cost

the cost of producing one more unit of a good slope of line output vs. total costs

operating leverage

the degree to which a project or firm is committed to fixed production costs low leverage, low fixed costs

sensitivity analysis

variation on scenario analysis useful in pinpointing areas where risk is especially severe; freeze all variables except one, see how sensitive npv is to one variable steeper line of variable vs. NPV, greater sensiitiviity

operating leverage and break even

when break even decreases, so does operating leverage

payback and breakeven

whenever a project breaks even on an accounting basis, cash flow for period will equal depreciation projects payback period is equal to its life if project breaks even every period project that breaks even on accounting basis has negative npv and zero return