Topic 7: CAPITAL PROJECT ANALYSIS &

EVALUATION
WhyconductCapitalProjectAnalysis(CPA)?
Why conduct Capital Project Analysis (CPA) ?

1. tominimizeforecasting/estimation
f / Riskk
probabilitythaterrorsinprojectedCFswill
leadtoincorrectdecisions
2. toavoiddecisionerror:
A positive NPV of a proposed project may
actually be negative, because CFs estimates
were inaccurate
(eg.Q,P,VC,FCmayeitherbeoverstated
or understated)
orunderstated)
AnegativeNPVmayactuallybepositive,
thusafirmwillloseavaluableopportunity
pp y

CPA thusallowsevaluationforvariousstateof
economyandsensitivityofvariablesaswellas
determiningminimumQtobeproduced
CapitalProjectAnalysis.

A. WhatIf
What IfAnalysis
Analysis

aimed at assessing the degree of

forecasting risk and to identify those
components that are the most critical to
the success or failure of an investment
FormsofWhatIfAnalysis

1. ScenarioAnalysis

calculating NPV of a proposed capital

project under
d different
d ff scenarios; worst
case (recession), base case (normal) and
best case (expansion)

Example: assigning worst

worstcase
case scenario
with lowest Q, lowest SP per unit and
highest costs, to test the NPV.
2. SensitivityAnalysis

assessingthechangeinNPVofacapital
projecttoachangeinonevariable
p j g where
forecastingriskissevere

Example:changetheSPperunit,and
other variables (Q VC FC) remain the same
othervariables(Q,VC,FC)remainthe
B BreakEvenAnalysis
B. BreakEven Analysis

acommontoolusedtoanalyze
relationshipbetweenQandprofitability

itassumestheproductionvolume(Q)
it assumes the production volume (Q)
isacrucialvariableforaproject

forecastingforhowmuchafirmcan
sell under the proposed project
sellundertheproposedproject
 analyzingQunderCashBreakEven,Accounting
y g , g
BreakEven,orFinancialBreakEven

1.AccountingBreakEven
1 Accounting Break Even
Salesvolume(Q)whenNI=0

NI= 0
0= [Q(SPperunit VCperunit) FC Depn](1T)

2. CashBreakEven
Salesvolume (Q)whenOCF=0
( )

OCF=0
0 =[Q(SPperunit
[Q(SP per nit VCperunit)
VC per nit) FC
FC Depn](1T)+Depn
Depn](1 T) + Depn
3 Fi
3. FinancialBreakEven
i lB k E
SalesVolume(Q)whenNPV=0

NPV =0
NPV 0
0 =PVofOCFs IO
=OCFs(PVIFA
OCF (PVIFA i,n)
) IO
C. OperatingLeverage
p g g

measures the responsiveness in operating

profit to a change in sales as the firm
introduces high percentage of fixed costs in its
total cost structure

Degree of Operating Leverage (DOL)

the percentage change in OCF relative to
percentage change
h i sales
in l volume
l (Q)
degree to which a firm relies on fixed costs
 the higher a firm
firmss FCs are,
are the higher is the
DOL

DOL = 1+ FC/OCF

A firm has high DOL if it incurs high fixed

costs, and
d therefore
h f poses a higher
hi h business
b i
risk
D. Financialleverage

measuretheresponsivenessinearningsper
share(EPS)toachangeinoperatingprofit(EBIT)
asthefirmuseshigherdebtandpreferredstock
financing.
financing

DegreeofFinancialLeverage(DFL)
D f Fi i lL (DFL)
thepercentagechangeinEPSrelativetothe
percentage change in debt financing cost
percentagechangeindebtfinancingcost
afirmhasahighDFL ifitincurshighcostofdebt
and preferred stock
andpreferredstock.
 DFL = EBIT
(EBIT Interest PSdiv)/(1T)

Where T =taxrate
PSdiv =cashdividendfor
preferredstock

E. Totalleverage/Degreeofcombined leverage
(DTL)

usedtodeterminetheoverallimpactofleverage.
DTL = DOLXDFL
Illustrations

(inclass)
 Managerial
ManagerialOptions(inCapitalBudgeting)
Options (in Capital Budgeting)
opportunitiesthatmanagerscanexploittomodifya
p j
projectafterithasbeenlaunched
toabandonortokeeptheproject
DCFanalysiscanberevised
DCF analysis can be revised

Capital
CapitalRationing
Rationing
a situation where a proposed investment has a
positive NPV but cannot find the necessary financing
 Soft Rationing
a situation where business units are allocated with
limited budget for capital project
can lead to by passing of projects having positive
NPVs, hence to choose the one with the largest
benefitcost ratio (profitability index)

Hard Rationing
a situation where a business cannot obtain any
financing at any circumstances
Sources:
PrinciplesofCorporateFinance,10th Edition,Brealey,Myers
andAllen,McGrawHillInternational,GlobalEdition,2011.
CorporateFinanceEssentials,7th Edition,Jordan,Westerfield
andRoss,McGrawHillInternational,GlobalEdition,2011.
CorporateFinance(FIN538/580),Mohd
C Fi (FIN538/580) M hd Amin,M.S,Institut
A i MS I i
Perkembangan Pendidikan (INeD),2008

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