Project Analysis and Evaluation

Why is accounting break-even useful?

- it is relatively easy to calculate and explain - based on estimated cash flows we may get a positive NPV but if the break-even revenue requires us to have a large portion of the market and this is unlikely then we may need to question our NPV - a project which just breaks even on an accounting basis loses money in an opportunity cost sense because we could have made money investing elsewhere

Explain what is meant by break-even analysis

Break even analysis is a technique for analysing how revenue, expenses and profit vary with changes in sales volume. It is used to determine the point at which revenue received equals the cost associated with receiving the revenue Costs in this context depend on the break even method: - accounting break even: costs are accounting expenses and break even point occurs when there is a net income of zero - cash break even: costs are operating cash flows and the break even point occurs when operating cash flow is zero - financial break even: costs are the net present value of all the relevant cash flows and the break even point occurs when net present value is zero

what is degree of operating leverage?

% change in OCF relative to % change in quantity sold

how is accounting break-even calculated?

(FC + D)/(P - v)

What equation can tell us the sales volume needed to achieve any given OCF?

(FC + OCF)/(P - v)

what is hard rationing?

the situation that occurs when a business cannot raise financing for a project under any circumstances

What is financial break-even?

the sales revenue that results in a zero NPV

how do we calculate DOL?

1 + FC/OCF

How do we calculate financial break-even?

1) find the OCF that results in an NPV of zero (investment/annuity factor) 2) use Q = FC + OCF / P - v to find break-even point

what are the similarities and difference of sensitivity and scenario analysis?

Scenario analysis is the determination of what happens to NPV estimates when we ask what-if questions. Whereas, sensitivity analysis is the investigation of NPV when only one variable is changed Scenario analysis allows all variables to be changed but for a limited range of values Sensitivity analysis allows one variable to be examined over a broad range

What is simulation analysis?

a combination of scenario and sensitivity analysis which lets all items vary at the same time and considers a large number of scenarios

why is financial break-even particularly important for investors?

a project can exceed the accounting and cash break-even points but still be below the financial break-even point A level of sales that reduces the NPV below zero causes a reduction in shareholder wealth.

How do we calculate a figure for sensitivity?

change in NPV/change in variable

What are the pros and limitations of scenario analysis?

no matter how many scenarios we run we can only learn possibilities it is useful in telling us what could happen and gauge the potential for disaster but does not tell us whether to take a project the worst case scenarios may not be low enough

What is sensitivity analysis useful for?

pinpointing areas where forecasting risk is high

what is an incremental cost?

the change in costs that occurs when there is a small change in output

what is operating leverage?

the degree to which a firm or project relies on fixed costs

what is scenario analysis?

the determination of what happens to NPV estimates when we ask what-if questions

what is sensitivity analysis?

the investigation of what happens to NPV when only one variable is changed

what is forecasting risk?

the possibility that errors in projected cash flows will lead to incorrect decisions

what is accounting break-even?

the sales level that results in a project net income of zero

What is cash break even?

the sales level that results in an OCF of zero

what is capital rationing?

the situation that exists if firm has positive NPV projects but cannot find the necessary financing

what is soft rationing?

the situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting