UNSW Business School

School of Banking and Finance

FINS5514: Capital Budgeting and Financial

Decisions

Lecture 4: The Investment Decision III

Project Cash Flows II and Estimating Risk in
Capital Budgeting

1
 Outline
_______________________________________________________________________________

• Pro-forma financial statements

• Depreciation
‒ Straight-line deprecation
‒ Modified accelerated cost recovery system
• Examples of capital budgeting decisions in
practice
• Break-even analysis
• Operating leverage

2
 Pro-forma Financial Statements
_______________________________________________________________________________

• So far, it has been assumed that project cash

flows are known with certainty.
• What if this is not true?
– In reality it is often difficult to know what cash flows a
project will produce.
– So the cash flows must be estimated.
• Pro-forma statements are projected financial
statements
– They are used to produce projected cash flows from
the project which are then used for capital budgeting
decisions.

3
 Pro-forma Financial Statements
_______________________________________________________________________________

• Pro-forma statements require information on:

– Net capital spending
– Net working capital
– Variable costs per unit
– Fixed costs
– Unit sales
– Selling price per unit

4
 Pro-forma Financial Statements
_______________________________________________________________________________

• Thus we can estimate project income:

ITEM DEFINITION
Sales Units sold x price per unit
Variable costs Units sold x variable costs per unit
Gross Profit Sales – Variable costs
Fixed costs Given information
Depreciation Given information
EBIT Gross Profit – (Fixed costs + Depreciation)
Taxes EBIT x tax rate
Net income EBIT – Taxes

5
 Pro-forma Financial Statements
_______________________________________________________________________________

• Using this information, we can also estimate

project capital requirements:
ITEM DEFINITION
Change in net working ΔNet working capital
capital
Net capital spending ΔNet fixed assets + Depreciation
Total investment Change in NWC+ Net capital spending

6
 Net working capital
_______________________________________________________________________________

• Why do we have to consider changes in NWC

separately?
₋ Sales may not translate immediately into cash inflows,
if customers buy on credit
₋ Expenses may not translate immediately into cash
outflows, if suppliers provide credit
₋ Finally, we have to increase inventory to support
sales; inventory will eventually turn into cash
• Changes in NWC adjust for the discrepancy
between the accounting of sales and costs, and
their actual cash receipts and payments
7
 Project Cash Flows
_______________________________________________________________________________

• Project cash flow is calculated as:

Project Cash Flow = Project Operating Cash Flow
– Project Change in Net Working Capital
– Project Net Capital Spending
• Where
Operating Cash Flow = EBIT + Depreciation − Taxes
• In addition, recall that net working capital will be
repaid at the end of the project, altering the final
year cash inflows
8
 Pro-forma Financial Statements
_______________________________________________________________________________

• Now we can estimate the project cash flows

Year 0 Year 1 Year 2 Year 3
Operating Nothing in Project cash Project cash Project cash
Cash Flow year 0 flows flows flows
Changes in Outflows for Inflow at end
Net Working project of project
Capital creation
Net Capital Outflows for Inflow at end
Spending project of project
creation
Total project Sum of the Sum of the Sum of the Sum of the
cash flow above above above above
9
 Pro-forma Income Statement
_______________________________________________________________________________

Sales (50,000 units at $4.00/unit) $200,000

Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 12,000
Depreciation ($90,000 / 3) 30,000
EBIT $ 33,000
Taxes (34%) 11,220
Net Income $ 21,780

10
 Projected Capital Requirements
_______________________________________________________________________________

Year
0 1 2 3
NWC $20,000 $20,000 $20,000 $20,000

NFA 90,000 60,000 30,000 0

Total $110,000 $80,000 $50,000 $20,000

11
 Projected Total Cash Flows
_______________________________________________________________________________

Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Change in -$20,000 20,000
NWC
NCS -$90,000

Project CF -$110,00 $51,780 $51,780 $71,780

Year 0 CF = cost of machinery and working capital investment

Year 1 OCF = EBIT + dep – tax = $33000 + 30000-11220 = $51780
Year 3 – recoup working capital investment
12
 Making The Decision
_______________________________________________________________________________

R = 20%
1 2 3

$ -110,000 CF1 = CF2 = CF3 =

51,780 51,780 71,780

NPV=-110,000+51,780/(1+0.2)+51,780/(1+ 0.2)2+ 71,780/(1+ 0.2)3

=10,647.69

IRR = ?
25.8%

13
 Depreciation
_______________________________________________________________________________

• Depreciation is a non-cash item

– Non-cash items track things such as changes to the value
of investments that have not been sold, and wear and tear
on valuable items
– Depreciation appears in as an income statement item
• Depreciation impacts the firm’s tax bill and, as
a result, has an impact on cash flows
– It must be considered in capital budgeting decisions
– The tax shield on depreciation is
Depreciation tax shield = T × Depreciation

14
 Straight Line Depreciation
_______________________________________________________________________________

• Straight line depreciation works by multiplying

the original asset cost by the depreciation rate
every year in which it is owned.
– This is the depreciation that can be claimed that year.
Depreciation = (Initial cost − Salvage )/ number of years
– Salvage here is book value of an asset at the end of useful
life

• Depreciation can be claimed each year, to the

end of its useful life, assuming the asset is owned
until it is fully depreciated
– A fully depreciated asset is one whose accumulated
depreciation equals its original cost.
15
 Straight Line Depreciation Example
_______________________________________________________________________________

• Consider an asset worth $25,000 that has

5-year economic life.
– Depreciation is at 20% per annum, straight line
– The asset has $0 salvage value

• At the end of the first year, the depreciation is:

Depreciation = Cost × Depreciation rate
Depreciation = 25,000× 20% = $5000

16
 Straight Line Depreciation Example
_______________________________________________________________________________

• If the asset were purchased part way through

the year so there were only 9 months until the
end of the fiscal year, the deprecation would
be:
Depreciation = (Cost × Depreciation rate )× Months owned
12

Depreciation = ($25,000×20%)× 9 = $3750

12

17
 Modified Accelerated Cost Recovery System (MACRS)
_______________________________________________________________________________

• An alternative method of calculating

depreciation, MACRS allocates every asset to a
particular depreciation class for tax purposes

• Each class specifies a sequence of percentages

which alter each year.
– To calculate depreciation, the initial cost of the asset is
multiplied by the relevant percentage for that year
– The asset is depreciated to zero

18
 Modified Accelerated Cost Recovery System (MACRS)
_______________________________________________________________________________

• MACRS depreciation allowances :

Property Class
Year 3-Year 5-Year 7-Year
1 33.33% 20.00% 14.29%
2 44.44 32.00 24.49
3 14.82 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.93
7 8.93
8 4.45

19
 Modified Accelerated Cost Recovery System Example
_______________________________________________________________________________

• Consider a $12,000 asset in the 5-year class

Year 5-Year Depreciation Starting Book Ending Book
(%) Value Value
1 20.00 0.20 x $12,000= $2,400.00 $12,000 $9,600.00
2 32.00 0.32 x $12,000 = $3,840 $9,600.00 $5,760.00
3 19.20 0.1920 x $12,000 = $2,304.00 $5,760.00 $3,456.00
4 11.52 0.1152 x $12,000 = $1,382.40 $3,456.00 $2,073.60
5 11.52 0.1152 x $12,000 = $1,382.40 $2,073.60 $691.20
6 5.76 0.0576 x $12,000 = $691.20 $691.20 0
100.00 $12,000.00

20
 After-tax Salvage
_______________________________________________________________________________

• If the salvage value of an asset is different

from the book value, then there is a tax effect
Book value = Initial cost - accumulated depreciation

After - tax salvage = salvage value - T(salvage value - book

value)
• Salvage value here is the market price that the
asset is sold.

21
 After-tax Salvage and Depreciation Example
_______________________________________________________________________________

• Some equipment is purchased for $100,000 and it

costs $10,000 to have it delivered and installed.
• Based on past information, you believe that you
can sell the equipment for $17,000 when you
are done with it in 6 years
• The marginal tax rate is 40%.
• What is the depreciation expense each year and
the after-tax salvage in year 6 for each of the
following situations?
– Straight line depreciation
– 3-years MACRS
22
 After-tax Salvage and Depreciation Example
_______________________________________________________________________________

• With Straight-line depreciation

Depreciation = (Initial cost − Salvage )/ number of years

Depreciation = (110,000 − 17,000)/ 6 = 15,500 eachyear

Book value in year 6 = 110,000 − (6×15,500)= 17,000

After - tax salvage = salvage value - T(salvage - book value)
After - tax salvage = 17,000 - 0.40(17,000 - 17,000)= 17,000

23
 After-tax Salvage and Depreciation Example
_______________________________________________________________________________

• With 3-Year MACRS

Year 3-Year Depreciation Starting Book Ending Book
(%) Value Value
1 33.33 0.3333 x $110,000= $36,663 $110,000 $73,337.00
2 44.44 0.4444 x $110,000 = $48,884 $73,337.00 $24,452.00
3 14.82 0.1482 x $110000 = $16,302 $24,452.00 $8,151.00
4 7.41 0.0741 x $110,000 = $8,151 $8,151.00 $0.00

BV in year 6 = 110,000 − (36,663 + 48,884 + 16,302 + 8,151)= 0

After - tax salvage = salvage value - T (salvage - book value )
After - tax salvage = 17,000 - 0.4(17,000 - 0 ) = $10,200
24
 Capital Budgeting Decisions in Practice - Cost Cutting Projects
_______________________________________________________________________________

• Sometimes facilities need to be upgraded to

remain efficient.
– The issue here is whether the savings are worth the costs
of the upgrade
• What to do here:
– What are the relevant cash flows?
– Are there working capital impacts? Usually not in this type
of project
– Depreciation will change – there is new equipment to
consider
– Taxes will also alter (due to changes in EBIT and
depreciation)

25
 Cost Cutting Example
_______________________________________________________________________________

• Walmart is considering a new system that will initially

cost $1 million.
• It will save $300,000 a year in inventory and
receivables management costs.
• The system is expected to last for five years and will be
depreciated using 3-year MACRS.
• There is no impact on net working capital.
• The marginal tax rate is 40% and the required return is 8%.
• The system is expected to have a salvage value of
$50,000 at the end of year 5.
– The after-tax salvage = salvage value – T( salvage – book value)
– Thus, the after-tax salvage value is 50,000 – 0.4(50,000 – 0) = $30,000
• Should Walmart install the new system?

26
 MACRS Depreciation Schedule
_______________________________________________________________________________

Year 1 2 3 4
Percentage 33.33% 44.44% 14.82% 7.41%

Depreciation 333.3 444.4 148.2 74.1

27
 Cost Cutting Example
_______________________________________________________________________________

Create a pro-forma income statement

Year 1 2 3 4 5
Cost savings 300,000 300,000 300,000 300,000 300,000

Depreciation 333,300 444,400 148,200 74,100 0

EBIT -33,300 -144,400 151,800 225,900 300,000
Taxes (@ 40%) -13,320 -57,760 60,720 90,360 120,000
OCF (EBIT + 313,320 357,760 239,280 209,640 180,000
Depreciation – tax)

Here the cost savings are the incremental project operating income

28
 Cost Cutting Example
_______________________________________________________________________________

Cash flow from assets:

Year 0 1 2 3 4 5
OCF 313,320 357,760 239,280 209,640 180,000
Net -1,000,000 30,000
Capital
Spend
Change
in NWC
CF -1,000,000 313,320 357,760 239,280 209,640 210,000

NPV = $83,795
The cost cutting project should be accepted.

29
 The Replacement Problem Example
_______________________________________________________________________________

• Ford considers replacing an old machine with a new

machine. If Ford buys the new machine today, the
old machine will be sold.
• The original machine:
• Initial cost = 100,000
• Annual depreciation = 9000
• Purchased 5 years ago
• Book value = 55,000
• Salvage today = 65,000
• Salvage in 5 years = 10,000
30 13
 The Replacement Problem Example
_______________________________________________________________________________

• The new machine:

• Initial cost = 150,000
• 5-year life and salvage in 5 years = 0
• Cost savings = 50,000 pa
• 3-year MACRS depreciation
• Required return = 10% and tax rate = 40%
• Should Ford replace the old machine with the new
machine?

31 14
 The Replacement Problem Example
_______________________________________________________________________________

• Remember that we are interested in incremental

cash flows
• If we buy the new machine, then we will sell the
old machine
• What are the cash flow consequences of selling
the old machine today instead of in 5 years?

32
 The Replacement Problem Example
_______________________________________________________________________________

Create a pro-forma income statement

Note - MACRS rates here are used with 2 decimal places only
[e.g. 0.33 instead of 0.3333]
Year 1 2 3 4 5
Cost savings 50,000 50,000 50,000 50,000 50,000

Depreciation
New asset 49,500 67,500 22,500 10,500 0
Old asset 9,000 9,000 9,000 9,000 9,000
Incremental CF 40,500 58,500 13,500 1,500 -9000
EBIT (Saving –Incremental) 9,500 -8,500 36,500 48,600 59,000
Taxes (@ 40%) 3,800 -3,400 14,600 19,400 23,600
Net income (EBIT – tax) 5,700 -5,100 21,900 29,100 35,400

33
 The Replacement Problem Example
_______________________________________________________________________________

• Consider the incremental capital spending

• Year 0
– Cost of new asset = 150,000 (outflow)
– After-tax salvage on old asset = 65,000 – 0.4(65,000 –
55,000) = 61,000 (inflow)
– Incremental new capital spending = 150,000 – 61,000 =
89,000 (outflow)

• And, Year 5
– After-tax salvage on old asset = 10,000 – 0.4(10,000-
10,000) = 10,000 (outflow as this is no longer received by
the firm)

34
 The Replacement Problem Example
_______________________________________________________________________________

Cash flow from assets:

Year 0 1 2 3 4 5
OCF (EBIT + 46,200 53,400 35,400 30,600 26,400
Depreciation-Taxes)
New Capital Spending -89,000 -10,000
Change in NWC 0 0
Cash flows for analysis -89,000 46,200 53,400 35,400 30,600 16,400

35
 The Replacement Problem Example
_______________________________________________________________________________

• Now analyse the cash flows, recalling the

required rate of return is 10%

• NPV = 54,853.07 (using 2 decimal places)

• IRR = 36.28%

• Therefore, the machine should be replaced.

36
 Alternative Definitions of Operating Cash Flow
_______________________________________________________________________________

• There are several different definitions of operating

cash flow
– All of these definitions should give the same answer
– However, sometimes one definition is more effective than
the others, depending on the information given

• The bottom-up approach starts from net income and

adds in non-cash deductions
‒ Works only when there is no interest expense
Project Net Income = EBIT − Taxes
OCF = Net Income + Depreciation
37
 Alternative Definitions of Operating Cash Flow
_______________________________________________________________________________

• The top-down approach starts with sales

subtracts costs, taxes etc.
– Non-cash items are left out in this case
OCF = Sales- Costs - Taxes
• The tax shield approach splits OCF into two
elements:
1. Cash flow without depreciation
2. The depreciation tax shield
OCF = (Sales - Costs )× (1- T )+ Depreciation ×T
38
 Equivalent Annual Cost Analysis
_______________________________________________________________________________

• Sometimes there are several different options

for equipment / manufacturing procedures
etc.
– The firm must choose the most cost effective option
– Often the options have different life spans which makes
comparisons more difficult
– With unequal lives, NPV rule can lead to the wrong
decision
• What to do here:
– To compare multiple projects, estimate the
equivalent annual cost (EAC)
– The EAC is the present value of a project’s costs,
calculated on an annual basis
39
 Equivalent Annual Cost Analysis
_______________________________________________________________________________

• Evaluate projects on an equal life basis ie take

into account all future replacement decisions
• EAC assumes infinite replacement
• Find the amount which is received each year for
n years that is equivalent to receiving the NPV of
a project whose life is n years

40
 Equivalent Annual Cost Analysis
_______________________________________________________________________________

• The EAC is estimated as:

EAC = PVcosts
At,r
• Where
1− 1 
 t
At,r = Annuity factor =  (1+ r ) 
r
• The project with the lowest EAC is the best one to
choose
41
 Investments of unequal lives
_______________________________________________________________________________

• Consider a factory that must have an air cleaner. The

equipment is mandated by law, so there is no “doing
without”
• There are two choices:
– The “Cadillac cleaner” costs $4,000 today, has annual
operating costs of $100 and lasts for 10 years
– The “cheaper cleaner” costs $1,000 today, has annual
operating costs of $500 and lasts for 5 years
• The discount rate is 10%
• Which one should we choose?
– Use NPV method
– Use EAC method
42
 The NPV Method
_______________________________________________________________________________

• At first glance, the cheaper cleaner has the higher NPV

(r = 10%):
10
$100
NPVCadillac = −$4,000 − ∑ t
= −4,614.46
t=1 (1.10)
5
$500
NPV cheap er = −$1,000 − ∑ t
= −2,895.39
t =1 (1.10)

• This overlooks the fact that the Cadillac cleaner lasts

twice as long

43
 Equivalent Annual Cost Method
_______________________________________________________________________________

– The Equivalent Annual Cost is the value of the level payment

annuity that has the same PV as our original set of cash flows
– NPV = EAC x At,r
– The Cadillac cleaner time line of cash flows:
-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100

0 1 2 3 4 5 6 7 8 9 10
10
$100
NPV Cadillac = −$4,000 − ∑ t
= −4,614.46
t =1 (1.10)

EAC = -4614.46/[(1-1/1.110)/0.1] = -750.98

44
 Equivalent Annual Cost Method
_______________________________________________________________________________

– The EAC for the Cadillac air cleaner is $750.98

Cheaper air cleaner:

– EAC = - 2,895.39 /[(1-1/1.15)/0.1] = -763.80
– The EAC for the cheaper air cleaner is $763.80
– When we incorporate the fact that the Cadillac cleaner
lasts twice as long as the cheaper air cleaner, the Cadillac
cleaner is actually cheaper

45
 Evaluating NPV estimates
_______________________________________________________________________________

• There can be issues with using NPV based on

estimates
• Using projected cash flows – what if the projections
are inaccurate?
– This is forecasting risk
– Projecting over longer periods increases the possibility of
error
– Highly competitive markets decrease the chance of
positive NPV investments. Potential competition cannot be
ignored

46
 Scenario Analysis
_______________________________________________________________________________

• Here the firm considers the NPV of an

investment under several different outcomes
– These are the best case, the worst case and the
base case (the most likely outcome)
– Other cases can be considered if required
• This is a way of determining the impact of
forecast errors
• The firm still has to decide whether to take
the project or not

47
 Scenario Analysis Example
_______________________________________________________________________________

Consider an investment that costs $200,000 and has a 5 year life.

There is no salvage and depreciation is straight line.
The required returns is 12% and the tax rate is 34%
In the base case, the NPV is $15,567 but there are three
scenarios to consider
Year Base Case Worse Best Case
Case
Unit Sales 6,000 5,500 6,500
Price per unit 80 75 85
VC per unit 60 62 58
FC 50,000 55,000 45,000

48
 Scenario Analysis Example
_______________________________________________________________________________

The pro-forma statements for these scenarios are:

Year Base Case Worse Case Best Case
Sales 480,000 412,500 552,500
VC 360,000 341,000 377,000
FC 50,000 55,000 45,000
Depreciation 40,000 40,000 40,000
EBIT 30,000 -23,500 90,500
Taxes 10,200 -7,990 30,770
Net income 19,800 -15,510 59,730

Base case: NI = 19,800; CF = 59,800; NPV = 15,567; IRR = 15.10%

Worse case: NI = -15.510; CF = 24,490; NPV = -111,719; IRR = -14.40%
Best case: NI = 59,730; CF = 99.730; NPV = 159,504; IRR = 40.90%
49
 Sensitivity Analysis
_______________________________________________________________________________

• This technique measures the impact on NPV

of a change to any one aspect of the project
whilst holding all other aspects the same
• This is a way of highlighting the impact of
forecasting errors on NPV calculations
• As before, the firm still has to determine
whether to accept the project or not

50
 Break-Even Analysis
_______________________________________________________________________________

• This is the analysis of the level of operations

necessary to cover all operating costs
– It is sometimes called cost-volume-profit analysis
– There will be a certain number of units that the company
must produce in order to cover its costs.

• Breakeven analysis is also used to:

– Evaluate the profitability associated with different levels of
sales

51
 Break-Even Analysis
_______________________________________________________________________________

• Variable costs (VC) are the product of the number

of units produced and the cost per unit
VC = Q×v
• Fixed costs (FC) are set during the investment
• Total costs (TC) are the sum of VC and FC

TC = VC + FC = Q×v + FC
• Sales are the product of price and the number of
units produced
S = P ×Q
52
 Break-Even Analysis
_______________________________________________________________________________
Costs / Revenue ($)

Fixed operating costs are a constant value

Sales (units)
53
 Break-Even Analysis
_______________________________________________________________________________

Adding variable
costs gives the
total operating
cost
Costs / Revenue ($)

Fixed costs

Sales (units)
54
 Break-Even Analysis
_______________________________________________________________________________

Adding Sales Revenue

Total Operating Costs
Costs / Revenue ($)

Fixed costs

Sales (units)
55
 Break-Even Analysis
_______________________________________________________________________________

Adding Sales Revenue

Total Operating Costs
Costs / Revenue ($)

Operating Break-even Point

Fixed costs

Sales (units)
56
 Break-Even Analysis
_______________________________________________________________________________

Adding Sales Revenue

Total Operating Costs
Costs / Revenue ($)

Below the break-even point, the project

makes a loss
Fixed costs

Sales (units)
57
 Break-Even Analysis
_______________________________________________________________________________

Adding Sales Revenue

Total Operating Costs
Costs / Revenue ($)

Above the break-even point, the project

makes money
Fixed costs

Sales (units)
58
 Break-Even Analysis
_______________________________________________________________________________

• Common tool for analyzing the relationship

between sales volume and profitability
• There are three common break-even measures
‒ Accounting break-even: sales volume at which
NI = 0
‒ Cash break-even: sales volume at which OCF = 0
‒ Financial break-even: sales volume at which
NPV = 0

59 11-58
 Break-Even Analysis
_______________________________________________________________________________

• Recall net income:

Net income = (Sales −Variable Costs - Fixed Costs - Depreciation)
× (1- T )

NI = (S - VC - FC - D)× (1− T )= (PQ - vQ - FC - D)× (1− T )

• Accounting break-even is the quantity of sales

that gives net income of zero

60
 Break-Even Analysis
_______________________________________________________________________________

• Rearranging for the quantity of units sold gives

NI = (PQ - vQ - FC - D)× (1− T )= 0

(PQ - vQ - FC - D ) = Q(P - v )− FC − D = 0
Q(P - v )= FC + D

(FC + D)
Q=
(P − v)

61
 Break-Even Analysis
_______________________________________________________________________________

•Accounting break-even and cash flow

Operating Cash Flow = EBIT + Depreciation - Taxes
OCF = (S − VC − FC − D ) + D - T

• We ignore taxes for simplicity

OCF = (S −VC − FC − D)+ D
OCF = QP − Qv − FC = Q(P − v) − FC
(OCF + FC )
Q= (P − v)
62
 Break-Even Analysis
_______________________________________________________________________________

• Cash break-even is the point at which OCF=0

• Financial break-even is the point at which

NPV=0
– This is found be estimating the level of OCF that
gives NPV=0
– Then work backwards to find the amount of sales
that equate to this level of OCF

63
 Break-Even Analysis Example
_______________________________________________________________________________

• A new product needs $5 million in initial investment and

depreciates to a salvage value of zero in 5 years
• The price of the new product is $25,000, variable cost
per unit is $15,000. Fixed costs are $1 million. The
required return is 18%
• Find:
– The accounting break-even point
– The operating cash flow at the accounting break-even point
(ignoring taxes)
– The cash break-even quantity and
– The financial break-even point

64
 Break-Even Analysis Example
_______________________________________________________________________________

• Start with the depreciation:

Depreciation = (Initial cost − Salvage )/ number of years

Depreciation = (5,000,000 − 0)/5 = 1,000,000

• Hence, the accounting break-even point is:

(FC + D) (1,000,000 + 1,000,000)
Q= = = 200 units
(P − v) (25,000 − 15,000)

65
 Break-Even Analysis Example
_______________________________________________________________________________

• Now the operating cash flow at the accounting

break-even point (ignoring tax):
Operating Cash Flow = EBIT + Depreciation
OCF = (S − VC − FC − D)+ D

OCF = ([200× 25,000]− [200× 15,000]− 1,000,000)

OCF = 1,000,000

66
 Break-Even Analysis Example
_______________________________________________________________________________

• Next, the cash break-even quantity

• Recall that this is the point at which OCF=0
OCF = (S − VC − FC − D ) + D = S − VC − FC

OCF = PQ − Qv − FC = Q(P − v )− FC

(OCF + FC ) (0 + 1,000,000)
Q = = = 100 units
(P − v) (25,000 − 15,000)
67
 Break-Even Analysis Example
_______________________________________________________________________________

• Finally, the financial break-even

• We know:
– Accounting break-even is 200 units
– Cash break-even is 100 units

• Financial break-even occurs when NPV=0

– We also know: n = 5, PV = 5,000,000, r = 18%.
– We need to know what OCF makes NPV = 0?

68
 Break-Even Analysis Example
_______________________________________________________________________________

• This question can be treated as an annuity

where C is the OCF:
1 1 
PVAt = C − t
 r r(1+ r ) 
 1 1 
5,000,000 = C − 5
 0.18 0.18(1.18) 
C = 1,598,889
69
 Break-Even Analysis Example
_______________________________________________________________________________

• Now, using the formula:

(OCF + FC ) (1,598,889 + 1,000,000)

Q = = = 260 units
(P − v) (25,000 − 15,000)

• Since this is the level of OCF that gives NPV =0, the
question becomes can we sell more than 260 units
per year?
– If we can, then the project will make money.

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 Break-Even Analysis Example
_______________________________________________________________________________

• This example gives the following:

– The accounting break-even point is 200 units
– Cash break-even is 100 units
– Financial break-even point 260 units

• This illustrates an important point:

Cash BE < Accounting BE < Financial BE

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 Operating Leverage
_______________________________________________________________________________

• Operating leverage measures the degree to

which a project relies on fixed costs
• It is also the relationship between the firm’s
sales revenue and EBIT
• A firm with a high proportion of fixed costs has
a high degree of operating leverage (DOL).
– This means that, if all other factors are held
constant, a small change in sales will bring about a
large change in ROE for a firm with a high DOL.

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 Operating Leverage
_______________________________________________________________________________

• Can a firm control the DOL?

– Operating leverage is strongly influenced by
technology. Some firms need a lot of fixed assets
and this increases operating leverage.
– By carefully selecting investments, a firm can exert
some control over its operating leverage by trying
to limit fixed costs as much as possible.
• The DOL will have an impact on business risk.
– If all other things are held constant, a firm with
high DOL will have high business risk

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 Operating Leverage
_______________________________________________________________________________

Operating leverage is measured using the

degree of operating leverage (DOL). This is the
percentage change in OCF relative to the
percentage change in quantity sold.
DOL = %∆OCF
%∆Q
• An alternative equation is:
DOL = 1 + FC
OCF
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 Operating Leverage Example
_______________________________________________________________________________

• Extending on the previous example.

• Suppose sales are 300 units which exceeds all
three break-even measures
• What is the DOL at this sales level?
• Recall, in the absence of taxes
OCF = Q(P − v )− FC

OCF = 300(25,000 − 15,000)− 1,000,000 = 2,000,000

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 Operating Leverage Example
_______________________________________________________________________________

• The DOL is:

DOL = 1 + FC = 1 + 1,000,000 = 1.5
OCF 2,000,000
• What happens to the OCF if unit sales increase
by 20%?
• Recall,
DOL = %∆OCF
%∆Q
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 Operating Leverage Example
_______________________________________________________________________________

• Rearranging the equation gives:

%∆OCF = DOL(%∆Q)
• Therefore,
%∆OCF = DOL(%∆Q)= 1.5(0.20) = 0.30 = 30%

• And the OCF would increase to:

2,000,000(1.3) = 2,600,000

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 Summary
_______________________________________________________________________________
• Pro-forma statements
• Depreciation
‒ Straight-line deprecation
‒ Modified accelerated cost recovery system
• Cost cutting and Replacement problem
• When a firm must choose between two machines
of unequal lives:
– the equivalent annual cost approach
• Break-even analysis
– Cash BE, accounting BE, financial BE
• Operating leverage
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