Unit 4 Project Analysis N Evaluation.docx

1、Unit 4 Project Analysis N EvaluationUNIT 4 PROJECT ANALYSIS AND EVALUATION4.1 Evaluating NPV EstimatesAn investment has a positive net present value if its market value exceeds its cost. Estimated NPV is positive is definitely a good sign. However, there are two circumstances under which a discounte

2、d cash flow analysis could lead us to conclude that a project has a positive NPV. The first possibility is that the project really does have a positive NPV and thats fine. The second possibility is that the project may appear to have a positive NPV because our estimate is inaccurate.4.1.1 Forecastin

3、g RiskThe key input into a DCF ( Discounted Cash Flows ) analysis are projected cash flows. If these projects are seriously in error, then we have a classic GIGO ( garbage-in, garbage-out ).The possibility that we make a bad decision because of errors in the projected cash flows is called forecastin

4、g risk. Because of forecasting risk, there is the danger that we might think that a project has a positive NPV when it really does not. This happens if we are overly optimistic about the future and, as a result, our projected cash flows dont realistically reflect the possible future cash flows.4.1.2

5、 Sources of ValueThe first line of defense against forecasting risk is simply to ask: “ What is it about this investment that leads to a positive NPV?. We should be able to point to something specific as the source of value.Some of the specific could be :1. Are we certain that our new product is sig

6、nificantly better than that of the competitor?2. Can we truly manufacture at a lower cost?3. Can we distribute our products more effectively?.4. Can we identify undeveloped market niches?.5. Can we gain control of the market?4.2 Scenario And Other “What if” AnalysesThe basic approach to evaluating c

7、ash flow and NPV estimates involves asking “ What if” questions. The goal here is to assess the degree of forecasting risk and to identify those components that are the most critical to the success or failure of an investment.4.2.1 Basic Procedure in Scenario AnalysesThe first thing to do in investi

8、gating a new project is to estimate the NPV based on projected cash flows. This is called the base case. Secondly, we would recognize that there a possibility of error in those cash flows projections.Thirdly, we investigate the impact of different assumptions about the future on the estimates. One w

9、ay to organize this investigation is to put an upper and lower bound on the various components. E.g. We forecast the sales at 6000 units per year and we are relatively certain that our estimate is accurate within 500 units in either direction. Similarly, selling price is estimated to be $80 $5 , var

10、iable cost per unit is $60 $2, expenditure per year is $50,000 $5,000. The initial cost of the investment is $200,000 and has a five-year life span and has no salvage value. The required rate of return is 12 percent and tax is 34 percent. The above information can be summarized as shown.Lower BoundB

11、ase case Upper BoundUnit sales5,5006,0006,500Price per unit $75 $80 $85Variable cost per unit $58 $60 $62Expenditure per year$45,000$50,000 $55,000Depreciation$40,000$40,000$40,000Depreciation per year = $200,000 /5 = $40,000 With this information, we can calculate the base-case NPV by calculating t

12、he net income.Sales = Unit sales x price 6,000 x 80 = $480,000Total Variable cost = Unit sales x variable cost per unit6,000 x 60 = 360,000Expenditure 50,000Depreciation 40,000EBIT ( Earning Before Interest and Tax ) $ 30,000Tax 34 % 10,200Net Income $19,8004.2.2 Scenario AnalysisThe basic form of w

13、hat-if analysis is called the scenario analysis. What we do is investigate the changes in our NPV estimates that result from asking questions like “What if the units sales realistically should be projected at 5,500 units instead of 6,000 Once we start looking at alternative scenarios, we might find

14、that most of the plausible ones result in positive NPVs. In this case, we have some confidence in proceeding with the project. If a substantial percentage of the scenarios look bad, then the degree of forecasting risk is high and further investigation is in order.There are a number of possible scena

15、rios we could consider. A good place to start is the worst-case scenario. This will tell us the minimum NPV of the project. If this were positive, we would be in good shape. We can also determine the other extreme, the best case. This puts an upper bound on the NPV.To get the worse case, we assign t

16、he least favorable value to each of the item. This means lowest values for items like units sold, price per unit and the highest value for costs.Consider the same example given earlier.Worst CaseBest CaseUnit sales 5,5006,500Price per unit $75 $85Variable cost per unit $62 $58Fixed costs$55,000 $45,

17、000With the above information, we can similarly calculate the cash flows, the net income, the NPV.4.2.3 Sensitivity Analysis.Sensitivity Analysis is a variation on scenario analysis that is useful in pinpointing the areas where forecasting risk is especially severe, The basic idea with a sensitivity

18、 analysis is to freeze all other the variables except one and then see how sensitive our estimate of NPV is to changes in that one variable. If our NPV estimate turns out to be very sensitive to relatively small changes in that variable, then the forecasting risk associated with that variable is ver

19、y high.In our example above, we can go back to the base case and then calculate the cash flows and NPV using the largest and smallest unit sales figures, with the rest of the variable remaining constant. Since there are many possibility, normally, such calculation is done with the aid of computer.Co

20、nsider another example with less variables to consider and could be calculated without the aid of a computer.E.g.A new project has the following forecasts : Initial Outlay$ 12,000Life 4 yearsNet annual cash inflows4,500Discount rate 14%Ignore taxation.The calculations of the sensitivity of the proje

21、ct to changes in each variable are as follows:Change in the initial outlay: ( Cash inflows remain the same )Let the initial outlay be changed to $x which will give a zero NPV.- x + 4 year annuity of $4,500 at 14% = 0- x + 4,500 x 2.914 = 0- x + 13,113 = 0x = $13,113The change in the outlay is from $

22、12,000 to $13, 113, that is, a change of $1,113The percentage change in outlay = 1,113 x 100 12,000 = 9.28%Change in the Life of the Project ( Initial Outlay remain the same )Let the life of the project be y years.- 12,000 + y years annuity at 14% = 0 y years annuity at 14% = 12,000 $4,500 x PVIFA =

23、 12,000 PVIFA = 12,000 4,500 = 2.667At the discount rate of 14%, notice:3 yearsy years4 years2.3222.6672.914By method of linear interpolation: . y - 3 = . 4 - 3 . 2.667 2.322 2.914 2.322 y 3 = 1 ( 0.345 ) 0.592 y = 3.58The change in the life span of the project is from 4 years to 3.58 , a decrease i

24、f 0.42 years.Percentage change in the life span = 0.42 x 100 4 = 10.5%Change in the Annual cash flow.Let the annual cash flow be changed to $B per yearNPV = -12,000 + $B x PVAF ( 4 years, 14 % )0 = -12,0000 + $B x 2.914$B = 4118Therefore Percentage change in annual cash flow = ( 4500 4118 ) x 100 45

25、00= 8.4 %Change in the Interest rate per yearLet the interest rate be H % per yearNPV = -12,000 + 45000 x PVAF( 4 years , H % )PVAF( 4 years, H % ) = 12,000 4500At the discount rate of 14%, notice:18 %H %19 %2.6902.6672.639By method of linear interpolation: . H - 18 = . 19 - 18 . 2.667 2.690 2.639 2

26、.690 H = 18.451Percentage change in interest = ( 18.451 14 ) x 100 14 = 31.79 %Conclusion : The project is most sensitive to the change in the interest rate.4.2.4 Simulation AnalysisIf we want to let all the items vary at the same time, we have to consider a very large number of scenarios and here,

27、computer assistance is certainly needed. In the simplest case, we start with unit sales and assume that any value of 5,500 to 6,500 ( consider the earlier example ), We can start by randomly picking one value ( or by instructing the computer to do so ). We then randomly pick a price, a variable cost

28、 and so on.Once we have values for all the relevant components, we calculate the NPV. We repeat this sequence as much as we desire , probably several thousand times. The result is a large number of NPV estimates we can summarize by calculating the average value and some measure of how spread out the

29、 difference possibilities are.4.3 Capital Rationing Capital rationing is said to exist when we have several profitable ( positive NPV ) investments available but we cannot get the needed funds to undertake them. For example, the division manager for a large corporation might identify a $ 3 million,

30、a $4 millions and a $5 million excellent profitable projects, but find that for whatever reasons, we can only spend $6 million. One of ways to overcome this problem is through capital rationing.4.4 Types and Sources of Capital RationingThere are two types of capital rationing and they are Internal a

31、nd External Capital rationing.4.4.1 Internal Capital RationingInternal Capital rationing is caused by the management pursuing policies which limit possible capital allocation to new project even if there is willing supply of finance from within the company or from external sources.Internal capital rationing is unlikely to be in the shareholders best interest in long term since it means that profitable projects which could be achieved are now forgone.Management may believe that some artificial limitation on the capital expendit