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FCFChap 11 IM
FCFChap 11 IM
FCFChap 11 IM
Chapter 11
Project Analysis and Evaluation
SLIDES
CHAPTER ORGANIZATION
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Chapter 11 - Project Analysis and Evaluation
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Chapter 11 - Project Analysis and Evaluation
There are two main reasons for positive NPVs: (1) we have a good
project or (2) we have done a bad job of estimating NPV.
C. Forecasting Risk
D. Sources of Value
The first and best guard against forecasting risk is to keep in mind
that positive NPVs are economic rarities in competitive markets. In
other words, for a project to have a positive NPV, it must have
some competitive edge – e.g., be first, be best, be the only. Keep in
mind the economic axiom that in a competitive market, excess
profits (the source of positive NPVs) are zero.
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Chapter 11 - Project Analysis and Evaluation
A. Getting Started
What things are likely to be wrong, and what will be the effect if
they are?
Start with a base case – the expected cash flows – then ask “what if
…?”
B. Scenario Analysis
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Chapter 11 - Project Analysis and Evaluation
A useful analogy for getting this point across is the market value
of a new car. The potential to be a “lemon” is in every car, as is
the possibility of being a “cream puff.” The greater the likelihood
that a car will have problems, the lower the price will be. The
point, however, is that a new car doesn’t have many different
prices right now – one for each conceivable repair record. Rather,
there is one price embodying the different potential outcomes and
their expected value. So it is with NPV – the potential for good and
bad cash flows is reflected in a single market value.
You might also want to point out that the cases examined in this
type of analysis typically aren’t literally the best and worst cases
possible. The true worst-case scenario is something absurdly
unlikely, such as an earthquake that swallows our production
plant. Instead, the worst-case used in scenario analysis is simply a
pessimistic (but possible) forecast used to develop expected cash
flows.
C. Sensitivity Analysis
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Chapter 11 - Project Analysis and Evaluation
D. Simulation Analysis
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Chapter 11 - Project Analysis and Evaluation
Variable costs (VC) are the costs that change as the volume of
sales changes (direct labor and materials, for example)
Fixed costs (FC) are those that are constant over a period
regardless of the level of sales.
Total costs (TC) are the sum of fixed costs and variable costs.
TC = FC + VC
TC = FC + (Q*v)
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Now point out that a company would have to expect more than
5,000 units in sales to justify accepting the increased fixed costs
and operating risk associated with project B. Additionally, the
forecasting risk is much greater with project B.
What sales level gives $0 net income (assuming things are the
same each year)? This happens when sales equal total costs.
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Q = (FC + D) / (P – v)
Q = (40,000 + 4,000) / (3 - .3) = 16,296 units
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Chapter 11 - Project Analysis and Evaluation
Setting OCF to 0 gives us the equation for the cash break-even quantity:
(QP –Qv – FC –D)(1-T) + D= 0
Q(P-v) (1-T) – FC (1-T) – D + DT + D = 0
Q(P-v) (1-T) = FC (1-T) + DT = 0
Q = [FC(1-T)-DT]/[(P-v)(1-T)]
OCF = (P – v)Q – FC
Q = (FC + OCF) / (P – v)
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Use a tax rate = 40% and rework the Wettways example from the
book:
You end up with a new quantity of 100 units. The firm must sell an
additional 16 units to offset the effects of taxes.
Since fixed costs do not change with sales, they make good
situations better and bad situations worse, i.e., they “lever” results.
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Chapter 11 - Project Analysis and Evaluation
Example:
FC = 40,000
D = 4,000
P=3
v = 0.30
T=0
At Q = 20,000, OCF = 14,000
In general, the lower the fixed costs and the degree of operating
leverage, the lower is the break-even point. If a project can be
started with low fixed costs and later switched to high fixed costs
(with lower variable costs per unit) if it turns out well, this is a
valuable option.
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Lecture Tip: In 2008, the economy was suffering from a real estate
and credit crisis. As a result, lenders essentially withdrew from the
market and credit dried up. This is a perfect example of an issue
that would create a situation very close to Hard Rationing for
many businesses.
Now ask the students to determine the break-even quantity for the
new procedure:
Fixed cost = 250,000 + 20,000 = 270,000
Variable cost = 50 + 30 + 750 = 830 per hour
Cash Break-Even = 250,000 / (3,000 – 830) = 115.2 hours,
or approximately 116 patients (assuming a one-hour procedure
per patient).
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