Corporate Finance Chapter 11 and Homework 4

Basic Problems

- NPV estimates are just that- estimates -positive NPV is a good start- now we need to take a closer look - There are two primary reasons for a positive NPV: (1) we have constructed a good project or (2) we have done a bad job estimating NPV

Marginal Cost

- The cost to produce one more unit - same as variable cost per unit

Average cost versus Marginal Cost

- There are three common break-even measures -Accounting Break-even: sales volume at which NI = 0 - Cash Break-even- sales volume at which OCF=0 -Financial Break-even: sales volume at which NPV=0

Average Cost

- Total cost/ number of units - will decrease as number of units increases

Capital Rationing

- occurs when a firm or division has limited resources - the situation that exists if firm has positive NPV projects but can not find the necessary financing.

Projected Versus actual cash flows

- we don't really expect a projected cash flow to be exactly right in any one case - our projections will be right on average

Hard Rationing

-capital will never be available for this project. - the situation that occurs when a business cannot raise financing for a project under any circumstance. - hard rationing can occur when a company experiences financial distress, meaning that bankruptcy is a possibility.

Sources of Value

-why does the project create value - the degree of competition in the market. A basic principle of economics is that positive NPV investments will be rare in a highly competitive environment.

Break-Even Analysis

A popular and commonly used tool for analyzing the relationship between sales volume and profitability. - the difference between fixed and variable costs becomes very important.

You are considering a project that you believe is quite risky. To reduce any potentially harmful results from accepting this project, you could: A)lower the degree of operating leverage B) lower the contribution margin per unit. C) increase the initial cash outlay. D) Increase the fixed costs per unit while lowering the contribution margin per unit.

A) Lower the degree of operating leverage

The Changes in Variable costs that occur when production is increased by one unit is referred to as the A) Marginal cost B) Average cost C) total cost D) net cost

A) Marginal Cost

Scenario Analysis is defined as the: A) determination of the initial cash outlay required to implement a project. B) determination of changes in NPV estimates when what-if questions are posed. C) isolation of the effect that a single variable has on the NPV of a project D) seperation of a project's sunk costs from its opportunity costs.

B) determination of changes in NPV estimates when what-if questions are posed.

The contribution margin per unit is equal to the: A) sales price per unit minus the total cost per unit. B) Variable cost per unit minus the fixed cost per unit C) sales price per unit minus the variable cost per unit. D) pre-tax profit per unit

C) Sales price per unit minus the variable cost per unit

An analysis which combines scenario analysis with sensitivity is called _____ analysis. A) Forecasting B) combined C) simulation D) Break-even

C) Simulation

Uptown promotions has three divisions. As part of the planning process, the CFO requested that each division submit its capital budgeting proposals for next year. These proposals represent positive NPV projects that fall within the long-range plans of the firm. The requests from the divisions are $4.2 million, $3.1 million, and $6.8 million, respectively. For the firm as a whole, the management of Uptown Promotions has limited spending to $10 million for new projects next year. This is an example of: A) scenario analysis B) Sensitivity analysis C) Soft rationing D) Hard rationing

C) Soft rationing

Variable Costs

Changes as the quantity of output changes, and they are zero when production is zero. - the relationship between total variable cost (VC), cost per unit of output (v), and total quantity of output (Q) can be written simply as: Total Variable cost= Total Quantity of Output x Cost per unit of Output. - VC= Q x v

Fixed Costs

Costs that do not change when the quantity of output changes during a particular time period.

Which of the following characteristics relate to the cash break-even point for a given project? I. the project never pays back. II. The IRR equals the required rate of return III. The NPV is negative and equal to the initial cash outlay. IV. The operating cash flow is equal to the depreciation expense

I and III only

Which of the following variables will be at their highest expected level under a worst case scenario? I. fixed cost II. sales price III. Variable Cost IV. Sales quantity

I and III only

Which of the following values will be equal to zero when a firm is producing the accounting break-even level of output? I. Operating Cash flow II. Internal Rate of Return III. Net income IV. payback period

II and III only

Accounting Break-Even Formula

Net Income = (Sales-Variable costs- Fixed costs- Depreciation) x (1 -Tax Rate) Net Income = (S-VC-FC-D) x (1-T) P: Selling Price per unit v: Variable cost per unit Q: Total units sold S: Total Sales P x Q VC: Total Variable Costs = v x Q FC: Fixed Costs D: Depreciation T: Tax Rate

How to calculate the Break-even point, we set the net income equal to zero

Net Income = 0 = (S- VC-FC-D) x (1-T) divide both sides by (1-T) to get: S-VC-FC-D = 0

Sales Volume and Operating Cash Flow

OCF = [ (P-v) x Q - FC - D] + D = (P-v) x Q - FC

Accounting Break-even and Cash Flow

Operating Cash Flow = EBIT + Depreciation - Taxes OCF = ( S - VC - FC - D) + D - 0

Payback and Break- Even

Project's Payback period is exactly equal to its life, if the project breaks even every period. Project that does better than a break even has a payback that is shorter than the life of the project and has a positive rate of return.

Capital intensive

Projects with a relatively heavy investment in plant and equipment will have a relatively high degree of operating leverage

Cash Break-even

Q = ( FC + 0) / (P - v) the sales level that results in zero operating cash flow

Accounting Break-even revisited

Q = ( FC + D) / ( P - v)

Financial Break-even

Q = (FC + OCF*) / (P - v) The sales level that result in a zero NPV

Break-Even Analysis

S-VC = FC+D P x Q -v xQ = FC + D (P - v) x Q = FC + D Q = ( FC + D) / (P - v)

Accounting Break-Even

The sales level that results in zero project Net income -the most widely used measure of break-even

Simulation Analysis

a combination of scenario and sensitivity analysis. - simulation is really just an expanded sensitivity and scenario analysis.

Sensitivity Analysis

investigation of what happens to NPV when only one variable is changed. - freeze all of the variable except one and then see how sensitive our estimate of NPV is to changes in that one variable. - for comparison, we now freeze everything except fixed costs and repeat the analysis: Scenario fixed costs cash flow net present value IRR

Operating Leverage

is the degree to which a project of firm is committed to fixed production costs.

Degree of Operating leverage (DOL)

the percentage change in operating cash flow relative to the percentage change in quantity sold - Percentage change in OCF = DOL x Percentage change in Q - DOL = 1 + FC / OCF - the ratio FC / OCF simply measures fixed costs as a percentage of total operating cash flow.

Scenario Analysis

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

Implication of Operating leverage

- the higher the degree of operating leverage, the greater is the potential danger from forecasting risk. - the reason is that relatively small errors in forecasting sales volume can get magnified, or "levered up, " into large errors in cash flow projections. - Highly uncertain projects is to keep the degree of operating leverage as low as possible.

Soft rationing

- the limited resources are temporary, often self-imposed. - the situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting. - if we face soft rationing, the first thing to do id to try to get a larger allocation. failing that, one common suggestion is to generate as large a net present value as possible within existing budget

Forecasting Risk

- the possibility that errors in projected cash flows will lead to incorrect decisions - Estimation risk - how sensitive is our NPV to changes in the cash flow estimates; the more sensitive, the greater the forecasting risk

Sensitivity Analysis

- the steeper the resulting line is, the greater the sensitivity of the estimated Npv to changes in the projected value of the variable being investigated. - if we find that our estimated NPV is especially to changes in a variable that is difficult to forecast (such as Unit sales), then the degree of forecasting risk is high.

As the degree of sensitivity of a project to a single variable rises, the: A) less important the variable to final outcome of the project. B) less volatile the project's net present value to that variable C) greater the importance of accurately predicting the value of that variable. D) greater the sensitivity of the project to the other variable inputs

C) greater the importance of accurately predicting the value of that variable.