CH 12 Fin

Fundamentals of Corporate
Finance
by
Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.
Chapter 12 Evaluating Project Economics and Capital Rationing
Copyright 2008 John Wiley & Sons
CHAPTER 12
Evaluating Project
Economics and Capital
Rationing
Quick Links
Variable Costs, Fixed Costs, & Project Risk
Calculating Operating Leverage
Break-Even Analysis
Risk Analysis
Capital Rationing
Variable Costs, Fixed Costs,

and Project Risk
Definitions
Variable costs (VC) are costs that vary directly
with the number of units sold.

Fixed costs (FC), in contrast, do not vary with unit
sales in the short run.
Exhibit 12.1: Unit and

Annual Costs for Hammock
Project

and Project Risk
Cash Flows and Profits
The cash flows and accounting profits for a
project are sensitive to the proportion of its costs

that are variable and the proportion that are fixed.
A project with a higher proportion of fixed costs
will have cash flows and accounting profits that

are more sensitive to changes in revenues than
an otherwise identical project with a lower
proportion of fixed costs.

and Project Risk
EBITDA is often called pretax operating cash flow
because it equals the incremental pretax cash

operating profits from a project.
EBITDA = Revenue Op Ex
where Op Ex = VC + FC
(12.1)
Exhibit 12.2: EBITDA under

Alternative Production
Technologies

and Project Risk
By comparing the sensitivity of EBITDA to
changes in revenue between two project

alternatives, it may help to better understand the
risks and returns for each of the alternatives.
Distinguishing between fixed and variable costs
will then enable us to calculate the sensitivity of

EBITDA to changes in revenue.
Exhibit 12.3: Changes in

EBITDA under Alternative
Production Technologies
10
Exhibit 12.4: EBITDA for

Different Levels of Unit
Sales
11

and Project Risk
The greater the proportion that total costs are
fixed will make it more difficult to adjust costs

when revenue changes.
EBIT is more sensitive to changes in revenue
than EBITDA because the EBITDA does not

include depreciation and amortization.
Depreciation and amortization acts just like a
fixed cost because it is based on the amount that

was invested in the project.
12
Exhibit 12.5: Changes in

EBITDA and EBIT
13
Using Excel Sensitivity

Analysis
14
Calculating Operating
Leverage
Definitions
Operating leverage is a measure of the sensitivity
of EBITDA or EBIT to changes in revenue.
Two measures of operating leverage are often
used by analysts: the degree of pretax cash flow

operating leverage and the degree of accounting
operating leverage.
15
Leverage
Degree of Pretax Cash Flow Operating Leverage

The degree of pretax cash flow operating
leverage (Cash Flow DOL) provides us with a

measure of how sensitive pretax operating
cash flows are to changes in revenue.
Cash Flow DOL 1
Fixed Costs
FC
1
(12.2)
Pretax operating cash flows
EBITDA
Cash Flow DOL changes with the level of
revenue; the sensitivity of operating cash flows

are not the same for all levels of revenue.
16
Leverage
Degree of Pretax Cash Flow Operating Leverage Example

Calculate the Cash Flow DOL for the automated
production alternative in Exhibit 12.2.
$35,000
Cash Flow DOL = 1+
= 1.64
$55,000
EBITDA in the denominator of equation 12.2
varies directly with revenue and will be larger
for larger amounts of revenue. The Cash
Flow DLO will be smaller as revenue
increases.
17
Exhibit 12.6: EBITDA with

Unit Sales
18
Leverage
Degree of Accounting Operating Leverage

The degree of accounting operating leverage
(Accounting DOL) is a measure of how

sensitive accounting operating profits, EBIT, are
to changes in revenue:
Fixed Charges
Accounting DOL 1
Accounting operating profits
FC D & A
1
EBITDA D & A
FC D & A
1
(12.3)
EBIT
19
Leverage
Degree of Accounting Operating Leverage Example

Calculate the Accounting DOL for the automated
production alternative in Exhibit 12.5 for expected
demand.
$35,000 + $10,000
Accounting DOL = 1+
$45,000
= 2.00
20
Leverage
Degree of Accounting Operating Leverage
D&A is treated as a fixed cost and is added to FC
to obtain the total of the cash and non-cash fixed

costs that would be reflected in the income
statement if the project were adopted.
21
Break-Even Analysis
Break-Even Analysis
Break-even analysis tells us how many units must
be sold in order for a project to break-even on a

cash flow or accounting profit basis.
Cash Flow Break-Even

The pretax operating cash flow (EBITDA) breakeven point is calculated as follows:
FC
EBITDA Break-even =
Price - Unit VC
22
(12.4)
Break-Even Analysis
Cash Flow Break-Even Example
Calculate the EBITDA break-even points for the
automated and manual production alternatives in
Exhibit 12.2.
$35,000
EBITDA Break-even Automated =
= 3,889 units
$25-$16
$4,000
EBITDA Break-evenManual =
= 800 units
$25-$20
23
Break-Even Analysis
Cash Flow Break-Even
The pre-tax operating cash flow break-even point
is important since it describes whether the firm's

pretax operating cash flow will be enough to keep
the project going without additional investment.
24
Break-Even Analysis
The Crossover Level of Unit Sales
The crossover level of unit sales (CO) is
calculated as follows:
COEBITDA
FCAlternative1 FCAlternative2
(12.5)
Unit contribution Alt.1 Unit contribution Alt.2
where Unit contribution stands for the per-unit

contribution.
25
Break-Even Analysis
The Crossover Level of Unit Sales Example
Calculate the Crossover level of unit sales for the
automated and manual production alternatives in
Exhibit 12.2.
COEBITDA
$35,000 - $4,000
=
$9 - $5
= 7,750 units
26
Break-Even Analysis
The Cross-Over Level of Unit Sales
The cross-over level of unit sales describes the
level above which one project alternative has

higher operating cash flows than another project
alternative.
When using the above formula, make sure that
the smaller value of FC is in the second term in

the numerator since putting the smaller number
first will usually give you a negative answer.
27
Exhibit 12.7: EBITDA BreakEven Points
28
Break-Even Analysis
Accounting Break-Even
The accounting operating profit (EBIT) break-
even point is calculated as:
FC+D & A
EBITBreak - Even =
.
Price-Unit VC
When we calculate the accounting operating profit
break-even point, we are calculating how many

units must be sold to avoid an accounting
operating loss.
29
Break-Even Analysis
Accounting Break-Even
In addition to the accounting profit break-even
points, we can also calculate the crossover level

of unit sales for EBIT as:
COEBIT
(FC D & A)Alt.1 (FC D & A)Alt.2
(12.7)
Unit contribution Alt.1 Unit contribution Alt.1
30
Break-Even Analysis
Accounting Break-Even Example
Calculate the accounting operating profit breakeven point and the crossover level of unit sales for
the automated and manual production alternatives
in Exhibits 12.1 and 12.2.
$35,000+$10,000
EBIT break-even Automated =
=5,000 units
$25-$16
$4,000+$1,000
EBIT break-evenManual =
=1,000 units
$25-$20
($35,000+$10,000)-($4,000+$1,000)
COEBIT =
=10,000 units
$9-$5
31
Risk Analysis
Risk Analysis
Financial analysts must often resort to different
types of risk analysis to obtain a better

understanding of how errors in forecasting these
factors affect the attractiveness of a project.
32
Risk Analysis
Sensitivity Analysis
Sensitivity Analysisinvolves examining the
sensitivity of the output from an analysis, such as

the NPV estimate, to changes in individual
assumptions.
In a sensitivity analysis, an analyst might examine
how a project's NPV changes if there is a

decrease in the value of individual cash inflow
assumptions or an increase in the value of
individual cash outflow assumptions.
33
Exhibit 12.8: Incremental

Free Cash Flows and NPV
34
Risk Analysis
Scenario Analysis
Scenario analysis will be performed if one wants
to examine how the results from a financial

analysis will change under alternative scenarios.
A scenario might describe how a set of project
inputs might be different under different economic

conditions.
By comparing the range of NPVs provided by the
different scenarios, it is possible to understand how
much uncertainty is associated with each NPV.
35
Exhibit 12.9: NPV Values for

Automated Hammock
Production
36
Risk Analysis
Simulation Analysis
Simulation analysis is like scenario analysis
except that in simulation analysis an analyst

typically uses a computer to examine a large
number of scenarios in a short period of time.
Rather than selecting individual values for each of
the assumptionssuch as unit sales, unit price,

and unit variable coststhe analyst assumes that
those assumptions can be represented by
statistical distributions.
37
Risk Analysis
Simulation Analysis
A computer program then calculates the cash
flows associated with a large number of scenarios

by repeatedly drawing numbers for the
distributions for various assumptions, plugging
them into the cash flow model, and computing the
annual cash flows and then the NPV.
In addition to providing an estimate of the
expected cash flows, simulation analysis provides

information on the distribution of the cash flows
that the project is likely to produce in each year.
38
Capital Rationing
Selecting the Best Projects
What does a firm do when it does not have
enough money to invest in all available positiveNPV projects?

The process of identifying the bundle of projects
that creates the greatest total value and allocating

the available capital to these projects is known as
capital rationing.
39
Capital Rationing
In an ideal world, the firm could accept all positive
NPV projects, because it would be able to finance

them.
However, the world is not ideal, and so the firm
must determine the most efficient method of

allocating its capital.
40
Capital Rationing
Capital Rationing in a Single Period
Capital Rationing in a Single Periodinvolves
choosing the set of projects that creates the

greatest value in a given period. The goal is to
select the projects that yield the largest value per
dollar invested.
The profitability index (PI) is computed for each
project and the firm then chooses the projects

with the largest profitability indices until it runs out
of money.
41
Capital Rationing
The objective is to identify the bundle or
combination of positive-NPV projects that

creates the greatest total value for stockholders.
Benefits Present Value of Future Cash Flows
PI
Costs
Initial Investment
NPV Initial Investment
(12.8)
Initial Investment
42
Capital Rationing
Profitability Index Example
Calculate the profitability index for the lawn mower
problem in Chapter 11. The new mower costs
$2,000 and brings in net cash flows of $7,000. The
discount rate is 10 percent and the NPV is $20,189.
$20,189 + $2,000
PI =
= 11.09
$2,000
43
Capital Rationing
The following steps should be taken:
1. Calculate the PI for each project.

2. Rank the projects from highest PI to
lowest PI.
3. Starting at the top of the list (the project with
the highest PI) and working our way down (to
the project with the lowest PI), we select the
projects that the firm can afford.
44
Capital Rationing
The following steps should be taken:
4. Repeat the third step by starting with the

second project on the list, the third project on
the list, and so on, to make sure that a more
valuable bundle cannot be identified.
45
Exhibit 12.10: Positive NPV

Investments
46
Capital Rationing
Capital Rationing Across Multiple Periods
If you are planning to make investments over
several years, the investments you choose this

year can affect your ability to make investments in
future years.
This can happen if you plan on reinvesting some
or all of the cash flows generated by the projects

you invest in this year.
47
Capital Rationing
Capital Rationing Across Multiple Periods
PI can only be relied upon to identify the projects
that the firm should invest in for this year.

A limitation of the profitability index is that it does
not tell us enough to make informed decisions

over multiple periods.
48
Exhibit 12.11: Positive NPV

Investments
49

CH 12 Fin

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH 12 Fin

Uploaded by

Copyright:

Available Formats

Fundamentals of Corporate

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Variable Costs, Fixed Costs,

with the number of units sold.

sales in the short run.

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Exhibit 12.1: Unit and

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Variable Costs, Fixed Costs,

project are sensitive to the proportion of its costs

A project with a higher proportion of fixed costs

will have cash flows and accounting profits that

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Variable Costs, Fixed Costs,

because it equals the incremental pretax cash

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Exhibit 12.2: EBITDA under

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Variable Costs, Fixed Costs,

changes in revenue between two project

Distinguishing between fixed and variable costs

will then enable us to calculate the sensitivity of

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Exhibit 12.3: Changes in

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Exhibit 12.4: EBITDA for

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Variable Costs, Fixed Costs,

fixed will make it more difficult to adjust costs

than EBITDA because the EBITDA does not

fixed cost because it is based on the amount that

Copyright 2008 John Wiley & Sons

Exhibit 12.5: Changes in

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Using Excel Sensitivity

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

of EBITDA or EBIT to changes in revenue.

Two measures of operating leverage are often

used by analysts: the degree of pretax cash flow

Chapter 12 Evaluating Project Economics and Capital Rationing

Copyright 2008 John Wiley & Sons

Degree of Pretax Cash Flow Operating Leverage

leverage (Cash Flow DOL) provides us with a

Cash Flow DOL changes with the level of

revenue; the sensitivity of operating cash flows

Copyright 2008 John Wiley & Sons

Degree of Pretax Cash Flow Operating Leverage Example

Copyright 2008 John Wiley & Sons