Finance- Chapter 11

Reasons the Accounting Break-Even is Useful:

1. Similar to payback period because it is relatively easy to calculate and explain. 2. Managers are often concerned with the contribution a project will make to a firm's total accounting earnings. A project that does not break-even in an accounting send actually reduces total earnings. 3. A project that just breaks even on an accounting basis loses money in a financial or opportunity cost sense. This is true because we could have earned more by investing elsewhere.

Net Income =

= (Sales - Variable Costs - Fixed Costs - Depreciation) x (1 - Tc) = (S - VC - FC - D) x (1 - Tc)

% change in quantity =

= (new quantity - initial quantity) / initial quantity

% change in OCF =

= DOL x % change in quantity

Variable costs

Costs that change when the quantity of output changes. -zero when production is zero. -exp: direct labor and raw material costs -Total Variable Cost = total quantity of output x cost per unit

Fixed costs

Costs that do not change when the quantity of output changes during a particular time period. -any fixed cost can be modified or eliminated given enough time. -effectively a sunk cost because we are going to have to pay it no matter what. -exp: lease payment on a facility or the company president's salary

Change in OCF =

DOL x change in quantity

Contribution margin per unit

Difference between selling price and variable cost per unit.

A project that just breaks even on an accounting basis:

Has a negative NPV and a zero rate of return.

Base Case

Initial set of projected cash flows when estimating NPV.

Capital Intensive

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

Break Even:

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

General Break-Even Expression:

Q = (FC +OCF) / (P - V)

Crucial variable for a project:

Sales volume

Total Costs

Sum of variable costs and fixed costs

Marginal/Incremental Cost

The change in costs thats occurs when there is a small change in output.

Marginal/Incremental Revenue

The change in revenue that occurs when there is a small change in output.

Operating Leverage

The degree to which a firm or project relies on fixed costs. - a firm with low operating leverage will have a relatively low amount of fixed costs compared to a company with high operating leverage.

Scenario Analysis

The determination of what happens to NPV estimates when we ask what-if questions. -basic form of what-if analysis -useful in telling us what can happen and in helping us gauge the potential for disaster, but it does not tell us whether to take a project.

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.

Degree of Operating Leverage

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

Forecasting Risk

The possibility that errors in projected cash flows will lead to incorrect decisions. -aslo known as estimation risk -the possibility that we will make a bad decision because of errors in the projected cash flows. -because of this, there is the danger that we will think a project has a positive NPV when it really does not.

Operating leverage declines as output (Q) rises:

The reason DOL declines is that fixed costs, considered as a percentage of operating cash flow, gets smaller and smaller, so the leverage effect diminishes.

Financial break Even

The sales level that results in a zero NPV. -First we determine what OCF has to be for the NPV to be zero and then use this amount to determine the sales volume. - OCF* = initial investment / annuity factor (OCF* is the OCF that results in a 0 NPV.) - Q = (FC + OCF*) / (P - V) -Substantially higher than the accounting break-even.

depreciation is a...

fixed cost

A project that does better than break even every period:

has a payback period shorter than its life and a positive rate of return.

The steeper the graph line:

the greater the sensitivity of the estimated NPV to changes in the projected value of the variable being invested.

A project's payback period is exactly equal to its life if:

the project breaks even every period

An investment has a positive NPV:

If its market value exceeds its cost. -its desirable because it creates value for its owner.

Sensitivity Analysis

Investigation of what happens to NPV when only one variable is changed. -variation on scenario analysis that is useful in pinpointing the areas where forecasting risk is especially severe. -basic idea is to freeze all of the variables except one and then see how sensitive our estimate of NPV is to changes in that one variable. -if our NPV estimate turns out to be very sensitive to relatively small changes in the projected value of some component of projected cash flow, then the forecasting risk associated with that variable is high. -useful in pinpointing which variables deserve the most attention. -useful for pointing out where forecasting errors will do the most damage, but it does not tell us what to do about possible errors.

Cash Break Even

The sales level that results in a zero operating cash flow. = Q = (FC + OCF) / (P - V), but we put a 0 in for OCF so it is really: Q = FC / (P - V) -tells us what sales volume (Q) is necessary to achieve any given OCF, so this is more general than the accounting break even. -an investment that just breaks even on an investment basis only covers its fixed costs and thats it, so the initial investment is a complete loss (IRR is -100%)

Accounting Break-Even

The sales level that results in zero project net income. -the most widely used measure of break-even. -depreciation is a part of fixed costs - Q = (FC + D) / (P - V)

Soft Rationing

The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting. -the corporation as a whole isn't short of capital; more can be raised on ordinary terms if management so desires. -if we face this, the first thing to do is get a larger allocation. If this fails, then try to generate as large the NPV as possible within the existing budget. So choose projects with the largest benefit-cost ratio (Profitability index). <-- only if it is a one-time event, not ongoing.

Operating Cash Flow =

= EBIT + Depreciation - Taxes = (S - VC - FC - D) + D - T = (P - V)xQ - FC

OCF new =

= OCF x (1 + % change in OCF)

Simulation Analysis

A combination of scenario and sensitivity analysis. -start by randomly picking one value, and then randomly pick a price, variable cost, and so on. -once we have values for all relevant components, we compute NPV. -Once we have the results, no simple decision rule tells us what to do. (Same drawback of scenario) -considers the interrelationships between the different cash flow components.

Break-Even Analysis

A popular and commonly used tool for analyzing the relationship between sales volume and profitability. -when revenues equal total costs -always be asking: "How bad do sales have to get before we actually begin to lose money?" & "Is it likely that things will get that bad?"

Capital Rationing

The situation that exists if a firm has positive NPV projects but cannot find the necessary financing. -said to exist when we have profitable (NPV) investments available but can't get the funds needed to undertake them.

Hard Rationing

The situation that occurs when a business cannot raise financing for a project under any circumstances. -can occur when a company faces financial distress, meaning that bankruptcy is possible. Or when a firm may not be belt o raise capital without violating a preexisting contractual agreement.