Chapter 10

PROJECT ANALYSIS

Professor Antoine Nehmé, CFA

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Edition
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
10-1 THE CAPITAL INVESTMENT PROCESS

• Capital Budget
• List of investment projects under consideration
by a firm
• Do not add fudge factors to cost of capital

• Postaudit
• Review of project to see if met forecasts

10-2
10-2 SENSITIVITY ANALYSIS
• Types of Analysis
• Sensitivity
• Analyzes effects of changes in sales, costs, etc., on project
• Scenario
• Project analysis given particular combination of
assumptions
• Simulation
• Estimates probabilities of different outcomes
• Break Even
• Level of sales (or other variable) at which project breaks
even

10-3
10-2 SENSITIVITY ANALYSIS

• Example
• Given expected cash-flow forecasts for Otobai
Company’s Motor Scooter project, determine
the NPV of project given changes in cash- flow
components using 10% cost of capital. Assume
constant variables, except the one you are
changing.

10-4
10-2 SENSITIVITY ANALYSIS

• Example, continued
Year 0 Years 1 - 10
Investment - 15
Sales 37.5
Variable costs 30
Fixed costs 3
Depreciati on 1.5
Pretax profit 3.0
Taxes @ 50% 1.5
Profit after tax 1.5
Operating cash flow 3.0
Net Cash Flow - 15 3

10-5
10-2 SENSITIVITY ANALYSIS

• Example, continued

Outcomes
Variable Pessimisti c Expected Optimistic
Market size .9 mil 1.0 mil 1.1 mil
Market share .04 .1 .16
Unit price 350,000 375,000 380,000
Unit var cost 360,000 300,000 275,000
Fixed cost 4 bil 3 bil 2 bil

10-6
10-2 SENSITIVITY ANALYSIS

• Example, continued
• NPV calculations—Optimistic scenario
Year 0 Years 1 - 10
Investment - 15
Sales 41.25
Variable costs 33
Fixed costs 3
Depreciati on 1.5
Pretax profit 3.75
Taxes @ 50% 1.88
Profit after tax 1.88
Operating cash flow 3.38
Net Cash Flow - 15  3.38
10-7
10-2 SENSITIVITY ANALYSIS

• Example, continued

Possibilit ies( Billions ¥)

Variable Pessimisti c Expected Optimistic
Market size 1.1 3.4 5.7
Market share - 10.4 3.4 17.3
Unit price - 4.2 3.4 5.0
Unit var cost - 15.0 3.4 11.1
Fixed cost 0.4 3.4 6.5

10-8
TABLE 10.3 NPV OF ELECTRIC SCOOTER

10-9
TABLE 10.3 ELECTRIC SCOOTER ASSUMPTIONS

10-10
TABLE 10.4 ELECTRIC SCOOTER SCENARIOS

10-11
TABLE 10.5 ELECTRIC SCOOTER ACCOUNTING
PROFIT

10-12
TABLE 10.1 ELECTRIC SCOOTER CASH-FLOW
FORECASTS

10-13
FIGURE 10.1 BREAK-EVEN CHART
• Point at which NPV=0 is break-even point
• Otobai Motors has a break-even point of 85,000
units sold
PV (Yen) PV inflows
Billions
Break-even
400 NPV = 0

200 PV
Outflows

19.6

85 200 Sales, thousands

10-14
FIGURE 10.2 ACCOUNTING BREAK-EVEN
• Accounting break-even does not consider time
value of money
• Otobai Motors has accounting break-even point
of 60,000 units sold
60 Revenues

Accounting Break -even

revenue and Profit =0
40
costs (Yen)
Billions
Costs
20

Sales, thousands
60 200 10-15
10-2 SENSITIVITY ANALYSIS

• Operating Leverage
• Degree to which costs are fixed

• Degree of Operating Leverage (DOL)

• Percentage change in profits given 1% change
in sales

DOL  % changein profits

% changein sales

or
fixed costs
DOL  1 
profits
10-16
10-2 SENSITIVITY ANALYSIS

• Example
• Using the data from the Otobai scooter project,
calculate the DOL

(3  1.5)
DOL = 1   2 .5
3

10-17
10-3 MONTE CARLO SIMULATION

• Modeling Process
• Step 1: Model Project
• Step 2: Specify Probabilities
• Step 3: Simulate Cash Flows
• Step 4: Calculate Present Value

10-18
FIGURE 10.3 SIMULATION OF CASH FLOWS

10-19
10-4 REAL OPTIONS AND DECISION TREES

• Decision Trees
• Diagram of sequential decisions and possible
outcomes
• Help companies analyze options by showing
various choices and outcomes
• Option to avoid a loss or produce extra profit
has value
• Ability to create option has value that can be
bought or sold

10-20
FIGURE 10.4 FEDEX’S EXPANSION OPTION

10-21
FIGURE 10.4 FEDEX’S EXPANSION OPTION

• Real Options
• Option to expand
• Option to abandon
• Timing option
• Flexible production facilities

10-22
FIGURE 10.6 DECISION TREE
$700 (.80)
- $130

.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130

Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130

$ 0 (.20)
10-23
FIGURE 10.6 DECISION TREE
$700 (.80)
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80

$ 0 (.20)
10-24
FIGURE 10.6 DECISION TREE
$700 (.80)
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130

700.80  0 .20  560 80

$ 0 (.20)
10-25
FIGURE 10.6 DECISION TREE
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
560
- $18 .50  130
NPV (upside)
.44 
- $130  295
1.096 3
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80

$ 0 (.20)
10-26
FIGURE 10.6 DECISION TREE
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
Invest .56 NPV = $52
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80
NPV = - $69
(do not invest, so NPV =
$ 0 (.20)
0)
10-27
FIGURE 10.6 DECISION TREE
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25 (0  .25)  (52  .5)  (295  .25)
NPV  $2 100 (.80)
NPV= ? - $130 1.096 
NPV = - $69  $83
80
(do not invest, so NPV =
$ 0 (.20)
0)
10-28
FIGURE 10.6 DECISION TREE
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= $19 NPV  18  (.-44  83)  (.56  0)
$130
 $19
NPV = - $69
80
(do not invest, so NPV =
$ 0 (.20)
0)
10-29
FIGURE 10.6 DECISION TREE
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= $19 - $130
80
NPV = - $69
(do not invest, so NPV =
$ 0 (.20)
0)
10-30