Chapter 10

PROJECT ANALYSIS

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
10-1 THE CAPITAL INVESTMENT PROCESS

Capital Budgeting
It is not just getting the NPV with the CF
forecast and project discount rate; the forecast
has to be correct and discount rate appropriate
Perform post-audits at the outset
It also involves Project Analysis, that is to
further analyze acceptable projects to improve
chance of success and to manage risk of failure

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10-2 PROJECT ANALYSIS
Sensitivity
Analyzes effects of changes in sales, costs, etc., on
project, one variable at a time, to see which one is
most sensitive in affecting NPV
Scenario
Analyzes the effect of changes in particular
combination of assumptions
Simulation
Estimates probabilities of different outcomes
Break Even
Level of sales (or other variable) at which project
breaks even
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10-2 SENSITIVITY ANALYSIS

Example (see pages 248-249)

Given expected cash-flow forecasts for Otobai
Companys Motor Scooter project, determine
the NPV of project given changes in cash-flow
components, using 10% cost of capital.
Assume constant variables, except the one you
are changing.

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10-2 SENSITIVITY ANALYSIS

Example, continued (Table 10.1)

Year 0 Years 1 - 10
Investment - 15
Sales 37.5
Variable costs 30
Fixed costs 3
Depreciati on 1.5
Pretax profit 3.0
Taxes @ 50% 1.5
Profit after tax 1.5
Operating cash flow 3.0
Net Cash Flow - 15 3

NPV=3.4 at 10% discount rate

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10-2 SENSITIVITY ANALYSIS
Example, make three forecasts of each
variable: pessimistic, most likely and
optimistic forecast
Outcomes
Variable Pessimisti c Expected Optimistic
Market size .9 mil 1.0 mil 1.1 mil
Market share .04 .1 .16
Unit price 350,000 375,000 380,000
Unit var cost 360,000 300,000 275,000
Fixed cost 4 bil 3 bil 2 bil

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10-2 SENSITIVITY ANALYSIS
Example, contd. Calculate NPV for each variable
with different forecast. The following table is NPV
with optimistic market size scenario (1.1m)
Year 0 Years 1 - 10
Investment - 15
Sales 41.25
Variable costs 33
Fixed costs 3
Depreciati on 1.5
Pretax profit 3.75
Taxes @ 50% 1.88
Profit after tax 1.88
Operating cash flow 3.38
Net Cash Flow - 15 3.38
NPV=5.7 at 10% discount rate 10-7
10-2 SENSITIVITY ANALYSIS
Example, contd. Arrange the NPVs in a table
below. What are the most sensitive variables? It
may be worthwhile to spend some money to
manage the high risk variables.

Possibilit ies ( Billions )

Variable Pessimisti c Expected Optimistic
Market size 1.1 3.4 5.7
Market share - 10.4 3.4 17.3
Unit price - 4.2 3.4 5.0
Unit var cost - 15.0 3.4 11.1
Fixed cost 0.4 3.4 6.5
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TABLE 10.3 SCENARIO ANALYSIS

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TABLE 10.3 SCENARIO ANALYSIS

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TABLE 10.4 BREAK-EVEN ANALYSIS

What is the break-even sales?

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FIGURE 10.1 BREAK-EVEN CHART
Point at which NPV=0 is break-even point
Otobai Motors has a break-even point of 85,000
units sold
PV (Yen) PV inflows
Billions
Break-even
400 NPV = 0

200 PV
Outflows

19.6

85 200 Sales, thousands

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TABLE 10.5 BREAK-EVEN ANALYSIS
How bad sales can get before the project begins
to lose money, i.e. showing negative NPV losses?

What is the accounting break-even

sales?
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FIGURE 10.2 ACCOUNTING BREAK-EVEN
Accounting break-even does not consider time
value of money
Otobai Motors has accounting break-even point
of 60,000 units sold
60 Revenues

Accounting Break -even

revenue and Profit =0
40
costs (Yen)
Billions
Costs
20

Sales, thousands
60 200 10-14
10-2 OPERATING LEVERAGE AND BEP

Operating Leverage
Degree to which costs are fixed

Degree of Operating Leverage (DOL)

Percentage change in profits given 1% change
in sales
DOL % change in profits
% change in sales

or
fixed costs
DOL 1
profits
Can you derive the second equation from the first?
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10-2 OPERATING LEVERAGE AND BEP

Example
Using the data from the Otobai scooter project,
calculate the DOL

(3 1.5)
DOL = 1 2.5
3
Profits will increase by 2.5% for a 1% increase
in sales.

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