PowerPoint PresentationTopics CoveredCapital Budgeting ProcessSlide 4How To Handle UncertaintySensitivity AnalysisSlide 7Slide 8Slide 9Slide 10Scenario AnalysisBreak Even AnalysisSlide 13Slide 14Slide 15Slide 16Slide 17Slide 18Operating LeverageSlide 20Flexibility & Real OptionsDecision TreesReal OptionsWeb ResourcesChapter 9Fundamentals of Corporate FinanceFifth EditionSlides byMatthew WillMcGraw Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Project AnalysisCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 2Topics CoveredHow Firms Organize the Investment ProcessSome “What If” QuestionsSensitivity AnalysisScenario AnalysisBreak Even AnalysisReal Options and the Value of FlexibilityCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 3Capital Budgeting ProcessCapital Budget - The list of planned investment projects.The Decision Process1 - Develop and rank all investment projects2 - Authorize projects based on:•Outlays required by law of company policy•Maintenance of cost reduction•Capacity expansion in existing business•Investment for new productsCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 4Capital Budgeting ProcessCapital Budgeting ProblemsConsistent forecastsConflict of interestForecast biasSelection criteria (NPV and others)Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 5How To Handle UncertaintySensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project.Scenario Analysis - Project analysis given a particular combination of assumptions.Simulation Analysis - Estimation of the probabilities of different possible outcomes.Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 6Sensitivity AnalysisExampleGiven the expected cash flow forecasts listed on the next slide, determine the NPV of the project given changes in the cash flow components using an 8% cost of capital. Assume that all variables remain constant, except the one you are changing.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 7Sensitivity Analysis7805,400-FlowCash Net 780flowcash Operating330after taxProfit 22040% @ .Taxes550profitPretax 450onDepreciati2,000Costs Fixed13,000Costs Variable16,000Sales5,400-Investment12-1 Years0Year Example – continued (,000s)NPV= $478Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 8Sensitivity AnalysisExample - continuedPossible Outcomes1,9002,0002,100)Costs(000s Fixed80%81.25%83%sales) of (%Cost Var 18,00016,00014,000)Sales(000s5,0005,4006,200(000s)InvestmentOptimisticExpectedcPessimistiVariableRangeCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 9Sensitivity AnalysisExample - continuedNPV Calculations for Pessimistic Investment Scenario7806,200-FlowCash Net 780flowcash Operating330after taxProfit 22040% @ .Taxes550profitPretax 450onDepreciati2,000Costs Fixed13,000Costs Variable16,000Sales6,200-Investment12-1 Years0Year NPV= ($121)Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 10Sensitivity AnalysisExample - continuedNPV Possibilities93047826)Costs(000s Fixed1,382478788-sales) of (%Cost Var 2,1744781,218-)Sales(000s778478121-(000s))000( InvestmentOptimisticExpectedcPessimistiVariablesNPVCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 11Scenario AnalysisExample - continuedCash Flows (years 1-12)2,018,000-478,000NPV3,382,0005,878,000flowscash of luePresent va448,000780,0007)(4 operations from flow8.Cash 1,200-330,000after taxProfit 7.800-220,0006.Taxes2,000-550,0004)-3-2-(1profit Pretax 5.450,000450,000onDepreciati 4.2,000,0002,000,000costs 3.Fixed11,152,00013,000,000costs Variable 2.000,600,13000,000,16Sales 1.Scenario. Store CompetingCase. BaseCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 12Break Even AnalysisExampleGiven the forecasted data on the next slide, determine the number of planes that the company must produce in order to break even, on an NPV basis. The company’s cost of capital is 10%.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 13Break Even Analysis12.5-Sold) s(3.5xPlane900-FlowCash Net 162.5-Sold) s(3.5xPlaneProfitNet 162.5-Sold) s(3.5xPlane(50%) Taxes325-Sold) (7xPlanesProfitPretax 150=900/6onDepreciati175Costs FixedSold 8.5xPlanesCost Var.Sold s15.5xPlaneSales$900Investment6-1 Years0YearCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 14Break Even AnalysisAnswer (Accounting)The break even point, is the # of Planes Sold where the fixed costs and depreciation = $0. planes 46.4162.5/3.5 sold Planes162.5)-Sold Planes x 3.5 (0Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 15Break Even AnalysisAnswer (Finance)The break even point, is the # of Planes Sold that generates a NPV=$0. The present value annuity factor of a 6 year cash flow at 10% is 4.355Thus, 12.5)-Sold Planes x 3.5 ( 535.4900 NPVCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 16AnswerSolving for “Planes Sold”12.5)-Sold Planes5.3( 355.49000 x63=Sold PlanesBreak Even AnalysisCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 17EVA & Break Even$266,553- millions) $2.45 - sales x (.1875 x .607) line - 6 line ( Added Value Economic 8.$266,553ondepreciati allowed above andover capital ofCost 7.millions) $2.45 - sales x (.1875 x .60profit accountingtax -After 6.millions) $2.45 - sales x (.1875 x .4040%) (asTax 5.million $2.45 - sales) x (.1875profitPretax 4.$450,000onDepreciati 3.million $2costs Fixed 2.sales ofpercent 81.25costs Variable 1.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin9- 18EVA & Break EvenEVA = accounting profit – additional cost of capital = 0($3.5 x planes sold - $162.50) - $56.6 = 0Planes sold = 219.1 / 3.5 = 62.6Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights