CORPORATE

FINANCE

S E S S I O N 3 : P R O J E C T A N A LY S I S
TWO BLADES BAD, THREE
BLADES GOOD?
• $750m development costs over six
years
• Had to build new (expensive)
factories
• $300m marketing budget in first year
• Launching in 100 countries within a
year
• Hoping customers will accept a 35%
cost rise

• How do we make a decision like this?

WHAT WE’LL LEARN TODAY

The complexities of deciding whether

to proceed with investing in a project
 F I R S T: A
You are considering investing in a start up REMINDER
project at a cost of $100,000.You expect QUESTION
the project to return $500,000 to you in
seven years. Given the risk of this project,
your cost of capital is 20%.

The NPV for this project is closest to:

A) $29,200
B) $39,500
C) $129,200
D) $139,500

What is the decision rule you should take

regarding this project?
 SOLUTION

• Answer: B ($39,500)
MAKING INVESTMENT
DECISIONS USING
THE NPV RULE
ESTIMATING EARNINGS
FROM A PROJECT
Linksys has completed a $300,000 feasibility study to assess the attractiveness of
a new product, HomeNet. The project has an estimated life of four years.

Revenue estimates

Sales 100,000 units/year

Per unit price $260

Cost estimates

Up-front R&D $15,000,000

Up-front new equipment* $7,500,000

Annual overhead $2,800,000

Per unit cost $110

* Expected life of the new equipment is 5 years. It will be housed in an

existing factory
EARNINGS FORECAST
NOTES:
• Capital Expenditure
– The $7.5 million in new equipment is a cash expense, but it is not
directly listed as an expense when calculating earnings. Instead, the firm
deducts a fraction of the cost of these items each year as depreciation.

• Straight Line Depreciation

– The asset’s cost is divided equally over its life.
Annual Depreciation = $7.5 million ÷ 5 years = $1.5 million/year

• Interest Expense
– In capital budgeting decisions, the interest expense is typically not
included. The rationale is that a project should be judged on its own, not
on how it will be financed.
OPPORTUNITY COSTS

– The value a resource could have provided in its best alternative use
– In the HomeNet project example, space will be required for the investment.
Even though the equipment will be housed in an existing lab, the
opportunity cost of not using the space in an alternative way (e.g., renting it
out) must be considered.
CANNIBALIZATION
Cannibalization occurs when sales of a new product displace sales of an
existing product

In the HomeNet example, 25% of sales come from customers who would have
purchased an existing Linksys wireless router if HomeNet were not available.
Because this reduction in sales of the existing wireless router is a consequence
of the decision to develop HomeNet, we must include it when calculating
HomeNet’s incremental earnings.
Opportunity cost

Not renting out factory $200,000

Existing router revenues and costs

Revenues

Sales 100,000

Per unit price $100

Costs

Per unit cost $60

UPDATED EARNINGS
FORECAST
WHAT NOT TO INCLUDE…

• Sunk costs
– Sunk costs are costs that have been or will be paid regardless of the
decision whether or not the investment is undertaken
– Sunk costs should not be included in the incremental earnings analysis

• Fixed Overhead Expenses

– Typically overhead costs are fixed and not incremental to the project and
should not be included in the calculation of incremental earnings

Slide N°13 : Bien sûr prendre en compte les coûts fixes qui sont générés par le nouveau
lancement
WHAT NOT TO INCLUDE…
• Past Research and Development Expenditures
– Money that has already been spent on R&D is a sunk cost and therefore
irrelevant
– Incremental cash in (out) flows of product are only relevant in decision to
continue or abandon a project

• Unavoidable Competitive Effects

– When developing a new product, cannibalization of existing products is
important factor
– However, if the decline in sales is inevitable, for instance because of new
products introduced by competitors, then these lost sales should be
considered a sunk cost
DETERMINING FREE CASH FLOW AND NPV
• The incremental effect of a project on a firm’s available cash is its free cash
flow (FCF) A L'EXAMEN

Unlevered Net Income

Free Cash Flow  (Revenues  Costs  Depreciation)  (1  c )

 Depreciation  CapEx  NWC

• Capital Expenditures are the actual cash outflows when>an asset

Actif is sheet
du balance
purchased. These cash outflows are included in calculating free cash flow
• Depreciation itself is a non-cash expense. The free cash flow estimate is
adjusted for this non-cash expense, however, depreciation is tax deductible
and this should be taken into account (hence initially including it and then
removing it in the FCF formula)
• Net Working Capital is the cash used in the day-to-day running of a
project, and is generally defined as Current Assets minus Current Liabilities.
This cash cost needs to be included and also the change from one year to
the next (unless otherwise told, the NWC is returned to the firm as an
income in the last year of a project)
NET WORKING CAPITAL
• Assume that working capital for the project requires us in any given
year to set aside 15% of sales for Current Assets (debtors, inventory,
etc), and allows us to have 15% of cost of goods sold as Current
Liabilities (creditors, expenses due but unpaid)
• All working capital will return to the firm the year after the project
ends (Year 5)
CALCULATING FREE CASH
FLOW

___ = paiement des

clients
CALCULATING THE NPV
FCFt 1
PV (FCFt )   FCFt 
(1  r ) t
(1  r )t
t  year discount factor

* Assume we are using a discount rate ‘r’ of 12%

Food For Less (FFL), a grocery store, is
considering offering one hour photo
developing in their store. The firm expects
QUESTION
that sales from the new one hour machine
will be $150,000 per year. FFL currently
offers overnight film processing with
annual sales of $100,000.
While many of the one hour photo sales
will be to new customers, FFL estimates
that 60% of their current overnight photo
customers will switch and use the one
hour service.

The level of incremental sales associated

with introducing the new one hour photo
service is closest to:
A) $90,000 B) $150,000
C) $60,000 D) $120,000
The total revenues from the one hour
photo machines are $150,000.
This includes new customers and old
customers which previously used the SOLUTION

overnight service. Due to the switch

by old customers, revenues from the
old service are estimated to drop by
60% or a reduction of $60,000.

This canabilization of the one hour

phote machine on the overnight
service needs to be taken into
account so that the overall
incremental revenue to the firm from
the one hour photo service is:
$150,000-$60,000 = $90,000 (A)
Glucose Scan Incorporated (GSI)
currently sells its latest glucose monitor,
the GlucoScan 3000, to diabetic patients
for $129. The cost of goods sold for each QUESTION
GlucoScan unit is $50, and GSI expects to
sell 100,000 units over the next year.
Suppose that if GSI drops the price on the
GlucoScan 3000 to $99 immediately, it can
increase sales over the next year by 30%
to 130,000 units. The incremental impact
of this price drop on the firms EBIT is
closest to:

A) a decline of 1.5 million

B) an increase of 1.5 million
C) a decline of 2.4 million
D) an increase of 2.4 million
At current prices GSI expects to have
an EBIT of: ($129-$50) x 100,000 = SOLUTION
$7.9m
(calculated as sales price minus costs
multiplied by volume)

A price drop lowers GSI’s margin but

increases its number of goods sold
generating an EBIT of: ($99-$50) x
130,000 = $6.37m

Thus lowering the price lowers the

EBIT by $1.53m (A)
The Sisyphean Corporation is considering investing in a
new cane manufacturing machine that has an estimated life
of three years. The cost of the machine is $30,000 and the
machine will be depreciated straight line over its three-
year life to a residual value of $0. QUESTION
The cane manufacturing machine will result in sales of
2,000 canes in year 1. Sales are estimated to grow by 10%
per year each year through year three. The price per cane
that Sisyphean will charge its customers is $18 each and is
to remain constant. The canes have a cost per unit to
manufacture of $9 each.
Installation of the machine and the resulting increase in
manufacturing capacity will require an increase in various
net working capital accounts. It is estimated that the
Sisyphean Corporation needs to hold 2% of its annual
sales in cash, 4% of its annual sales in accounts receivable,
9% of its annual sales in inventory, and 6% of its annual
sales in accounts payable. The firm is in the 35% tax
bracket, and has a cost of capital of 10%.
The incremental EBIT in the first year for the Sisyphean
Corporation's project is closest to:
A) $18,000 B) $8,000
C) $11,700 D) $5,200
Year 1 2 3

Units Sold 2,000 2,200 2,420

Sales $ 36,000 $ 39,600 $ 43,560

(units*$18) SOLUTION
COGS $ 18,000 $ 19,800 $ 21,780
(units*$9)
Gross Profit $ 18,000 $ 19,800 $ 21,780

Depreciation $ 10,000 $ 10,000 $ 10,000

($30,000/3)
EBIT $ 8,000 $ 9,800 $ 11,780

Income Tax $ 2,800 $ 3,430 $ 4,123

(35% of EBIT)

Net Income $ 5,200 $ 6,370 $ 7,657

Now calculate the NPV assuming WC is returned

at end of project (Year 4)…
Working Capital
Year 1 2 3 4

Sales 36000 39600 43560 0

CA WC (15%) 5400 5940 6534 0

SOLUTION
CL WC (6%) 2160 2376 2614 0

NWC (CA – CL) 3240 3564 3920 0

Change NWC +3240 +324 +356 -3920

FCF and NPV

Year 0 1 2 3 4

Net Income 5200 6370 7657

Plus: Depreciation 10000 10000 10000

Less: Capital Expense (30000)

Less: Increase in WC (3240) (324) (356) 3920

FCF (30000) 11960 16046 17301 3920

PV of FCF @ 10% (30000) 10873 13261 12999 2677

NPV 9810
SCENARIO
ANALYSIS
 SCENARIO ANALYSIS IS…

• Scenario analysis is the process of devising a

list of possible economic scenarios and
specifying the likelihood of each one as well as
the return that will be realised in each case

• This list of possible outcomes with associated

probabilities is generally known as a probability
distribution
 AN EXAMPLE OF SCENARIO
ANALYSIS
Consider an investment with the following
characteristics:

State of the Scenario Probability Return

Economy “s” “p(s)” “r(s)” / IRR

Boom 1 0.25 44%

Normal 2 0.50 14%

Recession 3 0.25 -12%

 EXPECTED RETURN
S
E r    ps r s 
s 1
p(s) = probability of a state
r(s) = return if a state occurs

• The expected return is the weighted average of returns in all possible

scenarios s = 1, … S with weights equal to the probability of that
particular scenario
 EXPECTED RETURN

Probability x Return
State of the Scenario Probability Return “p(s) x r(s)”
Economy “s” “p(s)” “r(s)” / IRR
Boom 1 0.25 44% 0.25 x 44% +
Normal 2 0.50 14% 0.50 x 14% +
Recession 3 0.25 -12% 0.25 x -12% =
= 21%
S
E r    ps r s 
s 1
VARIANCE
S
Var r   σ   ps r s   E r 
2 2

s 1

• Variance is the volatility (or “dispersion”) of

returns
• Variance tells us about the potential for deviation
of the return from its expected value
• The bigger the variance, the more the propensity
for rates of return to deviate from their expected
value
 VARIANCE

State of the Scenario Probability Return

Economy “s” “p(s)” “r(s)” E(r) = 14%

Boom 1 0.25 44% 0.25[44%-21%]2+

Normal 2 0.50 14% 0.50[14%-21%]2+
Recession 3 0.25 -12% 0.25[-12%-21%]2=
= 429

S
Var r   σ 2   ps r s   E r 
2

s 1
STANDARD DEVIATION

S
SDr   σ   ps rs   Er   VAR r 
2

s 1

• Standard deviation is simply the square root of variance

• In the current example, the standard deviation (“σ”) = 4291/2 = 20.71%
MEAN + STANDARD
DEVIATION
FINISHING UP…
WHAT WE LEARNED TODAY

• NPV can help us make decisions on whether or not to proceed with

an investment / project, but this is complicated by a number of issues:
– The need to estimate revenues and costs
– The need to account for opportunity costs
– The need to account for cannibalization of existing firm activities
• Scenario analysis allows us to estimate potential gains and risks for an
uncertain future where there are a number of realistic outcomes
CONNECTING TODAY TO THE
EXAM

You should be familiar with how to

account for all the possible complexities of
applying NPV for investment decision
making. You should also be familiar with
how to estimate returns and risk in a
scenario analysis. The questions at the end
of Chapter 6 will be particularly useful.