Unit 4 Project Analysis N Evaluation.docx

Unit 4 Project Analysis N Evaluation.docx

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Unit4ProjectAnalysisNEvaluation

UNIT4

PROJECTANALYSISANDEVALUATION

4.1EvaluatingNPVEstimates

Aninvestmenthasapositivenetpresentvalueifitsmarketvalueexceedsitscost.EstimatedNPVispositiveisdefinitelyagoodsign.However,therearetwocircumstancesunderwhichadiscountedcashflowanalysiscouldleadustoconcludethataprojecthasapositiveNPV.ThefirstpossibilityisthattheprojectreallydoeshaveapositiveNPVandthat’sfine.ThesecondpossibilityisthattheprojectmayappeartohaveapositiveNPVbecauseourestimateisinaccurate.

4.1.1ForecastingRisk

ThekeyinputintoaDCF（DiscountedCashFlows）analysisareprojectedcashflows.Iftheseprojectsareseriouslyinerror,thenwehaveaclassicGIGO（garbage-in,garbage-out）.

Thepossibilitythatwemakeabaddecisionbecauseoferrorsintheprojectedcashflowsiscalledforecastingrisk.Becauseofforecastingrisk,thereisthedangerthatwemightthinkthataprojecthasapositiveNPVwhenitreallydoesnot.Thishappensifweareoverlyoptimisticaboutthefutureand,asaresult,ourprojectedcashflowsdon’trealisticallyreflectthepossiblefuturecashflows.

4.1.2SourcesofValue

Thefirstlineofdefenseagainstforecastingriskissimplytoask:

“WhatisitaboutthisinvestmentthatleadstoapositiveNPV?

.Weshouldbeabletopointtosomethingspecificasthesourceofvalue.

Someofthespecificcouldbe:

1.Arewecertainthatournewproductissignificantlybetterthanthatofthecompetitor?

2.Canwetrulymanufactureatalowercost?

3.Canwedistributeourproductsmoreeffectively?

.

4.Canweidentifyundevelopedmarketniches?

.

5.Canwegaincontrolofthemarket?

4.2ScenarioAndOther“Whatif”Analyses

ThebasicapproachtoevaluatingcashflowandNPVestimatesinvolvesasking“Whatif”questions.Thegoalhereistoassessthedegreeofforecastingriskandtoidentifythosecomponentsthatarethemostcriticaltothesuccessorfailureofaninvestment.

4.2.1BasicProcedureinScenarioAnalyses

ThefirstthingtodoininvestigatinganewprojectistoestimatetheNPVbasedonprojectedcashflows.Thisiscalledthebasecase.

Secondly,wewouldrecognizethatthereapossibilityoferrorinthosecashflowsprojections.

Thirdly,weinvestigatetheimpactofdifferentassumptionsaboutthefutureontheestimates.Onewaytoorganizethisinvestigationistoputanupperandlowerboundonthevariouscomponents.

E.g.

Weforecastthesalesat6000unitsperyearandwearerelativelycertainthatourestimateisaccuratewithin500unitsineitherdirection.Similarly,sellingpriceisestimatedtobe$80$5,variablecostperunitis$60$2,expenditureperyearis$50,000$5,000.Theinitialcostoftheinvestmentis$200,000andhasafive-yearlifespanandhasnosalvagevalue.Therequiredrateofreturnis12percentandtaxis34percent.Theaboveinformationcanbesummarizedasshown.

LowerBound

Basecase

UpperBound

Unitsales

5,500

6,000

6,500

Priceperunit

$75

$80

$85

Variablecostperunit

$58

$60

$62

Expenditureperyear

$45,000

$50,000

$55,000

Depreciation

$40,000

$40,000

$40,000

Depreciationperyear=$200,000/5

=$40,000

Withthisinformation,wecancalculatethebase-caseNPVbycalculatingthenetincome.

Sales=Unitsalesxprice

6,000x80=$480,000

TotalVariablecost=Unitsalesxvariablecostperunit

6,000x60=360,000

Expenditure

50,000

Depreciation

40,000

EBIT（EarningBeforeInterestandTax）

$30,000

Tax@34%

10,200

NetIncome

$19,800

4.2.2ScenarioAnalysis

Thebasicformofwhat-ifanalysisiscalledthescenarioanalysis.WhatwedoisinvestigatethechangesinourNPVestimatesthatresultfromaskingquestionslike“Whatiftheunitssalesrealisticallyshouldbeprojectedat5,500unitsinsteadof6,000

Oncewestartlookingatalternativescenarios,wemightfindthatmostoftheplausibleonesresultinpositiveNPVs.Inthiscase,wehavesomeconfidenceinproceedingwiththeproject.Ifasubstantialpercentageofthescenarioslookbad,thenthedegreeofforecastingriskishighandfurtherinvestigationisinorder.

Thereareanumberofpossiblescenarioswecouldconsider.Agoodplacetostartistheworst-casescenario.ThiswilltellustheminimumNPVoftheproject.Ifthiswerepositive,wewouldbeingoodshape.Wecanalsodeterminetheotherextreme,thebestcase.ThisputsanupperboundontheNPV.

Togettheworsecase,weassigntheleastfavorablevaluetoeachoftheitem.Thismeanslowestvaluesforitemslikeunitssold,priceperunitandthehighestvalueforcosts.

Considerthesameexamplegivenearlier.

WorstCase

BestCase

Unitsales

5,500

6,500

Priceperunit

$75

$85

Variablecostperunit

$62

$58

Fixedcosts

$55,000

$45,000

Withtheaboveinformation,wecansimilarlycalculatethecashflows,thenetincome,theNPV.

4.2.3SensitivityAnalysis.

SensitivityAnalysisisavariationonscenarioanalysisthatisusefulinpinpointingtheareaswhereforecastingriskisespeciallysevere,ThebasicideawithasensitivityanalysisistofreezeallotherthevariablesexceptoneandthenseehowsensitiveourestimateofNPVistochangesinthatonevariable.IfourNPVestimateturnsouttobeverysensitivetorelativelysmallchangesinthatvariable,thentheforecastingriskassociatedwiththatvariableisveryhigh.

Inourexampleabove,wecangobacktothebasecaseandthencalculatethecashflowsandNPVusingthelargestandsmallestunitsalesfigures,withtherestofthevariableremainingconstant.Sincetherearemanypossibility,normally,suchcalculationisdonewiththeaidofcomputer.

Consideranotherexamplewithlessvariablestoconsiderandcouldbecalculatedwithouttheaidofacomputer.

E.g.

Anewprojecthasthefollowingforecasts:

InitialOutlay

$12,000

Life

4years

Netannualcashinflows

4,500

Discountrate

14%

Ignoretaxation.

Thecalculationsofthesensitivityoftheprojecttochangesineachvariableareasfollows:

Changeintheinitialoutlay:

（Cashinflowsremainthesame）

Lettheinitialoutlaybechangedto$xwhichwillgiveazeroNPV.

-x+4yearannuityof$4,500at14%=0

-x+4,500x2.914=0

-x+13,113=0

x=$13,113

Thechangeintheoutlayisfrom$12,000to$13,113,thatis,achangeof$1,113

Thepercentagechangeinoutlay=1,113x100

12,000

=9.28%

ChangeintheLifeoftheProject（InitialOutlayremainthesame）

Letthelifeoftheprojectbeyyears.

-12,000+yyearsannuityat14%=0

yyearsannuityat14%=12,000

$4,500xPVIFA=12,000

PVIFA=12,000

4,500

=2.667

Atthediscountrateof14%,notice:

3years

yyears

4years

2.322

2.667

2.914

Bymethodoflinearinterpolation:

.y-3=.4-3.

2.667–2.3222.914–2.322

y–3=1（0.345）

0.592

y=3.58

Thechangeinthelifespanoftheprojectisfrom4yearsto3.58,adecreaseif0.42years.

Percentagechangeinthelifespan=0.42x100

4

=10.5%

ChangeintheAnnualcashflow.

Lettheannualcashflowbechangedto$Bperyear

NPV=-12,000+$BxPVAF（4years,14%）

0=-12,0000+$Bx2.914

$B=4118

ThereforePercentagechangeinannualcashflow

=（4500–4118）x100

4500

=8.4%

ChangeintheInterestrateperyear

LettheinterestratebeH%peryear

NPV=-12,000+45000xPVAF（4years,H%）

PVAF（4years,H%）=12,000

4500

Atthediscountrateof14%,notice:

18%

H%

19%

2.690

2.667

2.639

Bymethodoflinearinterpolation:

.H-18=.19-18.

2.667–2.6902.639–2.690

H=18.451

Percentagechangeininterest=（18.451–14）x100

14

=31.79%

Conclusion:

Theprojectismostsensitivetothechangeintheinterestrate.

4.2.4SimulationAnalysis

Ifwewanttoletalltheitemsvaryatthesametime,wehavetoconsideraverylargenumberofscenariosandhere,computerassistanceiscertainlyneeded.Inthesimplestcase,westartwithunitsalesandassumethatanyvalueof5,500to6,500（considertheearlierexample）,Wecanstartbyrandomlypickingonevalue（orbyinstructingthecomputertodoso）.Wethenrandomlypickaprice,avariablecostandsoon.

Oncewehavevaluesforalltherelevantcomponents,wecalculatetheNPV.Werepeatthissequenceasmuchaswedesire,probablyseveralthousandtimes.TheresultisalargenumberofNPVestimateswecansummarizebycalculatingtheaveragevalueandsomemeasureofhowspreadoutthedifferencepossibilitiesare.

4.3CapitalRationing

Capitalrationingissaidtoexistwhenwehaveseveralprofitable（positiveNPV）investmentsavailablebutwecannotgettheneededfundstoundertakethem.Forexample,thedivisionmanagerforalargecorporationmightidentifya$3million,a$4millionsanda$5millionexcellentprofitableprojects,butfindthatforwhateverreasons,wecanonlyspend$6million.Oneofwaystoovercomethisproblemisthroughcapitalrationing.

4.4TypesandSourcesofCapitalRationing

TherearetwotypesofcapitalrationingandtheyareInternalandExternalCapitalrationing.

4.4.1InternalCapitalRationing

InternalCapitalrationingiscausedbythemanagementpursuingpolicieswhichlimitpossiblecapitalallocationtonewprojectevenifthereiswillingsupplyoffinancefromwithinthecompanyorfromexternalsources.

Internalcapitalrationingisunlikelytobeintheshareholders’bestinterestinlongtermsinceitmeansthatprofitableprojectswhichcouldbeachievedarenowforgone.

Managementmaybelievethatsomeartificiallimitationonthecapitalexpendit