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Lecture05 sp08
Lecture05 sp08
Introduction
The calculation of the NPV (net present value) requires many forecasts including
• sales quantities
• prices
• variable costs, and
• fixed costs.
The uncertainty of the forecasts leads to uncertainty about the NPV. In this lecture, we
will learn some techniques that help a manager make better-informed decisions using
NPV analysis. These techniques are sensitivity analysis, scenario analysis, and break-
even analysis.
1
Example: BIKE Corporation is considering the introduction of a motor scooter. The
staff has put together the following cash-flow forecasts (figures in millions of dollars).
The initial cost of this project is $150 million. Assume a discount rate of 10%. Find the
NPV.
Calculation of Revenue:
= (1,000,000)(0.10)($3,750)
= $375,000,000
2
Calculation of NPV if the expected occurs
1
1 −(1 +.10 )10
NPV = −$150 +$30 =$34 .34
.10
Question 1: Your forecasters are extremely concerned about their assumption regarding
market share. They feel it is extremely likely that BIKE will only capture 4% of the
market. How will this impact the decision? Recalculate the NPV for the project.
Question 2: Go back to the original assumptions. Now assume that forecasters think that
a possibility exists that the unit variable costs might only be $2,750. How will this
impact the decision? Recalculate the NPV for the project.
The above calculations are an example of sensitivity analysis. The table below shows the
results of sensitivity analysis on all the estimates used to arrive at cash flows.
3
Sensitivity Analysis
The range of NPV depends on the choice of optimistic and pessimistic assumptions.
4
Break-Even Analysis
Break-even sales levels can be calculated in terms of both accounting profit and
present value.
Present value break-even uses the equivalent annual cost of the initial
investment. The equivalent annual cost is the amount we would have to pay for
the initial investment if we divided it up evenly over its lifetime taking into
account the time value of money.
This value is known as the contribution margin since it represents the additional
amount that each motor scooter contributes to after-tax profit.
5
Accounting Break-even is the number of scooters that makes after-tax profits equal to
after-tax annual accounting costs.
Practice 1: You are considering investing in a fledgling company that cultivates abalone
for sale to local restaurants. The proprietor says he’ll return all profits to you after
covering operating costs and his salary.
a) How many abalone must be harvested and sold in the first year of operations for you to
get any payback? (Assume no depreciation.)
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Present Value Break-Even
Note: The initial investment was $150 million. Use the annuity equation to obtain
the Equivalent Annual Cost (EAC).
Present Value Break-Even is the number of scooters that makes after-tax profits equal to
after-tax annual economic costs.
7
Practice 2: Given the information from Practice 1, what is the present value break-even
point if the discount rate is 15 percent, initial investment is $140,000, and the life of the
project is seven years? Assume a straight-line depreciation method with a zero salvage
value.