NPV Breakeven Analysis

Definition
• The NPV break-even analysis identifies the
level of sales necessary to produce a zero level
of NPV.
• It differs from accounting break-even analysis
in that NPV break-even focuses on cash flows,
not accounting profits.
 Accounting Break-even
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Revenues (12,500 units x $190 each) $ 2,375,000 $ 2,375,000 $ 2,375,000 $ 2,375,000 $ 2,375,000
less: Variable cost ($160 per unit) -2,000,000 -2,000,000 -2,000,000 -2,000,000 -2,000,000
less: Depreciation expense -90,000 -90,000 -90,000 -90,000 -90,000
less: Fixed cash costs per year -285,000 -285,000 -285,000 -285,000 -285,000
Net Operating Income $ - $ - $ - $ - $ -
less: Taxes (Tax rate = 30%) 0 0 0 0 0
Net Operating Profit after Tax (NOPAT) $ - $ - $ - $ - $ -
plus: Depreciation expense 90,000 90,000 90,000 90,000 90,000
less: Increase in CAPEX $ -500,000 0 0 0 0 50,000
less: Increase in working capital -20,000 0 0 0 0 20,000
Free Cash Flow (FCF) $ -520,000 $ 90,000 $ 90,000 $ 90,000 $ 90,000 $ 160,000

NPV $ -135,365
IRR 0

• The sum of cashflows from Year 1 to 5 is equal to the initial cash out
in Year 0.
• Sales revenue od $2,375,000 will give us zero accounting profits.
 NPV Break-even
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Revenues (14,200 units x $190 each) $ 2,698,000 $ 2,698,000 $ 2,698,000 $ 2,698,000 $ 2,698,000
less: Variable cost ($160 per unit) -2,272,000 -2,272,000 -2,272,000 -2,272,000 -2,272,000
less: Depreciation expense -90,000 -90,000 -90,000 -90,000 -90,000
less: Fixed cash costs per year -285,000 -285,000 -285,000 -285,000 -285,000
Net Operating Income $ 51,000 $ 51,000 $ 51,000 $ 51,000 $ 51,000
less: Taxes (Tax rate = 30%) -15,300 -15,300 -15,300 -15,300 -15,300
Net Operating Profit after Tax (NOPAT) $ 35,700 $ 35,700 $ 35,700 $ 35,700 $ 35,700
plus: Depreciation expense 90,000 90,000 90,000 90,000 90,000
less: Increase in CAPEX $ -500,000 0 0 0 0 50,000
less: Increase in working capital -20,000 0 0 0 0 20,000
Free Cash Flow (FCF) $ -520,000 $ 125,700 $ 125,700 $ 125,700 $ 125,700 $ 195,700

NPV 0
IRR 10%
• NPV = 0 if PV (cash flows) = C0
• Under IRR of 10%, NPV is zero when revenue is equal
to $2,698,000.
Graphically:
 Break-Even Analysis
– Using the accounting break-even, the project
had to generate sales of $2.375 million to have
zero profit.
– Using the NPV break-even, we find that the
project needs sales of $2.698 million to have a
zero NPV.

 The project needs to be 14% more successful to

break-even on a NPV basis!
 Question
• Accounting Break-Even
– If a project breaks even in accounting terms is it
an acceptable investment?

Would you be happy with an investment

which after 5 years gave you a zero total rate
of return?
Principle 1: Money Has
a Time Value
 Operating Leverage and the
Volatility of Project Cash Flows
 Definition
• Operating leverage results from the use of
fixed costs in the operations of the firm and
measures the sensitivity of changes in
operating income to changes in sales.
 Basic Idea of Operating Leverage
• Operating leverage is the degree to which a
project or firm is committed to fixed production
costs.
• A firm with low operating leverage will have low
fixed costs compared to a firm with high
operating leverage.
• Generally speaking, projects with a relatively
heavy investment in plant and equipment will
have a relatively high degree of operating
leverage. Such projects are said to be capital
intensive.
 Degree of Operating Leverage
• Degree of operating leverage (DOL) tells us
when there is a percent change in sales, how
that is reflected in a percent change in Net
Operating Income (NOI).
 DOL Equation

• If DOL = 1, then a 1% change in sales will produce a

1% change in profits.
• If DOL = 50, then a 1% change in sales will produce a
50% change in profits.
 Application
• The risk of a project is affected by its DOL.
• If a large proportion of the project’s costs are
fixed, then DOL will be high.
• If DOL is high, then any shortfall in sales will
have a magnified effect on profits.
• In other words, high DOL means high risk if
sales do not work out as forecasted!
Table 13-1 How Operating Leverage Affects NOI for a 20%
Increase in Longhorn’s Sales

Table 13-2 How Operating Leverage Affects NOI for a 20%

Decrease in Longhorn’s Sales
 DOL in a nutshell
• Operating leverage results from substitution of
fixed operating costs for variable operating
costs.
• The effect of operating leverage is to increase the
effect of changes in sales on operating income.
• The degree of operating leverage (DOL) is an
indication of the firm’s use of operating leverage.
The DOL decreases as the level of sales increases
beyond the break-even point.
• Operating leverage is a double-edged sword,
magnifying both profits and losses, helping in the
good times and causing pain in the bad times
 Summary
– Successful managers know that the
forecasts behind NPV calculations are
imperfect.
– Thus, they explore the consequences to the
firm of a poor forecast.
– They check whether the project is really
worth pursuing by doing some additional
homework.
• This consists of asking a series of “what-if”
questions to determine the feasibility of the
project and its risk profile.
 Summary
– The principal tools used by managers in
“what-if” questions are:
• Sensitivity Analysis
• Scenario Analysis
• Simulation Analysis
• Break-Even Analysis
• Operating Leverage
– A desirable characteristic in a project is
flexibility.