chapter9

Accounting Break Even

(Fixed Costs + Dep)*(1-t) / (Sales Price - Var. Cost)*(1-t)

Revenue estimates depend on these 2 assumptions

1. Market share 2. Size of market 3. Price/Unit

3 forecasts to perform in a sensitivity analysis

1. pessimistic 2. expected/best 3. optimistic

what does a sensitivity analysis do?

1. reduce a false sense of security 2. show us where more info is needed however! you cannot be subjective with what merits optimistic or pessimistic!

Monte Carlo Simulation Steps

1. specify the model 2. specify distributions 3. crunch the numbers 4. do this a few thousand times

Fixed Costs

A cost that is not dependent on the amount of goods or services produced during the period.

Variable Costs

A cost that varies directly with volume and is zero when production is zero.

decision tree

A graphical representation of alternative sequential decisions and the possible outcomes of those decisions.

contribution margin

Amount that each additional sale contributes to the profit of the whole project.

Monte Carlo Simulation

An exercise that generates possible outcomes for a project based on a model of the underlying factors that drive project performance.

Scenario Analysis

Analysis of the effect on a project of different scenarios with each scenario involving many variable changes.

Sensitivity Analysis

Analysis of the effect on the project when there is some change in a critical variable such as sales or costs

Break-even analysis

Analysis of the level of sales at which a project would earn zero profit.

Financial Break Even

Analysis of the level of sales at which a project would have an NPV of zero.

What is forecasting risk? In general, would the degree of forecasting risk be greater for a new product or a cost-cutting proposal?

Forecasting risk is the risk that a poor decision is made because of errors in projected cash flows. The danger is greatest with a new product because the cash flows are probably harder to predict.

As a shareholder of a firm that is contemplating a new project, would you be more concerned with the accounting break-even point, the cash break-even pointing, or the financial break-even point?

From the shareholder perspective, the financial break-even point is the most important. A project can exceed the accounting and cash break-even points but still be below the financial break-even point. This causes a reduction in shareholder wealth.

A co-worker claims that looking at all this margins this and incremental that is just a bunch of nonsense and states: "Listen, if our average revenue doesn't exceed out average cost, then we will have a negative cash flow, and we will go broke!" How do you respond?

Is is true that if average revenue sis less than average cost, the firm is losing money. This much of the statement is therefore correct, At margin, however, accepting a project with marginal revenue in excess of its marginal cost clear acts to increase OCF.

How does sensitivity analysis interact with break-even analysis?

Sensitivity analysis can determine how the financial break-even point changes when some facts (such as fixed costs, variable costs, or revenue) change

Assume a firm is considering a new project that requires an initial investment and has equal sales and costs over its life. Will the project require the account, cash, or financial break-even point first? Next? Last?

The project will reach the cash break-even first, the accounting break-even next, and finally the financial break-even. For a project with an initial investment and sales after this ordering will always apply. The cash break-even is achieved first since it excludes depreciation. The accounting break-even is next since it includes depreciation. Finally, the financial break-even, which includes the time value of money, is achieved. `

The Mango Republic has just liberalized its markets and is now permitting foreign investors. Tesla has analyzed starting a project in the country and has determined that the project has a negative NPV. Why might the company go ahead with the project? What type of option is most likely to add value to this project?

The type of option is most likely to affect the decision is the option to expand. If the country just liberalized its markets, there is likely the potential for growth. First entry into a market can give a company name recognition and market share. This may make it more difficult for competitors entering the market.

A timber company has the option to log timbre today or wait another year to log the timber. What advantages would waiting another year have?

There are 2 sources of value within this decision to wait. Potentially, the price of the timber can increase, and the amount of timber will almost definitely increase (unless there is a natural disaster, that is). The option to wait for a logging company is quite valuable, and companies in the industry have models to estimate the future growth of a forest depending on its age.

Why does traditional NPV tend to underestimate the true value of a capital budgeting project?

Traditional NPV analysis is often too conservative because it ignores profitable options such as the ability to expand the project if it is profitable, or abandon the project if it is unprofitable. The option to alter a project when it has already been accepted has value, which increases the NPV of the project.

What is the essential difference between a sensitivity analysis and a scenario analysis?

With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario analysis, all variables are examined for a limited range of values.

Financial Break Even Formula

[EAC + Fixed Costs*(1-t) - (Dep*t)] / [(Sales Price - Var. Costs)*(1-t)]

Real Options

adjustments that a firm can make after a project is accepted: types include 1. expansion 2. abandonment 3. timing