Lecture 8 (Chapter 11): Project Analysis and Evaluation

Transcription

1 Lecture 8 (Chapter 11): Project Analysis and Evaluation Discounted cash flow analysis is a very powerful tool, but it is not easy to use. We have already seen one difficulty: How do we identify the cash flows? Today we begin to focus on a second difficulty: What if our cash flows are not certain? Risk plays a crucial part in DCF analysis. To understand cash fl ow risk, we will use several tools: Scenario analysis Sensitivity analysis Break-even analysis Operating leverage Simulation analysis Lecture 8: Project Analysis and Evaluation 1 Capital Rationing Definition: A situation where a firm has positive NPV projects, but cannot obtain funding to undertake them. Soft Rationing: Firm sets internal limits on capital available to its divisions. Used by firms as an alternative means of controlling investments where DCF is too hard or not understood. Hard rationing: Capital markets refuse to finance the firm. If the firm was willing to pay a high enough rate, could it find someone to invest? If so, perhaps the opportunity cost of capital was calculated incorrectly. If not, perhaps the cash flows are not correct. Market inefficiency (asymmetric information) Lecture 8: Project Analysis and Evaluation 2 1

2 Evaluating NPV Estimates The cash flows that we use in DCF analysis are projections of the future. What will be the effect if these projections turn out to be inaccurate? Forecasting risk: bad projections can lead to bad decisions One way to look for problems in DCF is to ask: Why should we expect this project to have a positive NPV? The project must be better than all the alternatives available to the investor (opportunity cost of capital) Where is the source of value? Innovation, Low cost, Market niche, Economies of scale/scope How competitive is the market? Lecture 8: Project Analysis and Evaluation 3 What-if Analysis What happens if our projections turn out to be wrong? Start with a Base Case that gives our best estimate of the future cash flows. Then vary the cash flows using Scenario analysis: imagine different possible states of the world, and project cash flows and NPVs for each state. Sensitive analysis: change one input variable and see how this affects the resulting NPV. Break-even Analysis: find the value of an input variable (typically sales) that sets the projects NPV to zero Operating Leverage: the degree to which a change in sales impacts the NPV Simulation analysis: use random variables as inputs and calculate NPV many times to determine the distribution of possible NPVs. Lecture 8: Project Analysis and Evaluation 4 2

3 Example Base Case Fairways Driving Range expects rentals to be 20,000 buckets at $3 per bucket. Equipment costs $20,000 and will be depreciated straight-line over 5 years and have a $0 salvage value. Variable costs are 10% of rentals and fixed costs are $45,000 per year. Assume no increase in working capital nor any additional capital outlays. The required return is 15% and the tax rate is 15%. Lecture 8: Project Analysis and Evaluation 5 Scenario Analysis Imagine three states of the world: Base case (our best estimate) Rent 20,000 buckets Variable costs are 10% of revenues Best case (everything works out perfectly) Rent 25,000 buckets Variable costs are 8% of revenues Worst case (nothing goes like it should) Rent 15,000 buckets Variable costs are 12% of revenues How will this change our decision? Lecture 8: Project Analysis and Evaluation 6 3

4 Sensitivity Analysis Change only one input variable at a time and see how the NPV is affected. Find which assumptions are the most important We can then spend more time checking these assumptions Gives us an idea of the riskiness (variability) of our NPV estimate Focus on variables that cannot be directly controlled by the firm to see the effects of nature on our project. For example, try optimistic and pessimistic values. Lecture 8: Project Analysis and Evaluation 7 Break-Even Analysis Find the level of sales that the project must achieve to have a positive NPV Remember finding the bid price from Lecture 7? Set NPV = 0 and solve for sales. Often it won t be so easy to solve by hand. Question: What is the break-even level of the discount rate called? Lecture 8: Project Analysis and Evaluation 8 4

5 Accounting Break-Even Analysis Level of sales that results in zero EBIT and Net Income EBIT = Sales*3*(1-0.1) 45,000 4,000 = 0 Sales = 18,148 General formula: Sales = (FC + Dep)/(Price var cost) Note that when EBIT = 0, Net Income = EBIT*(1-tax) = 0 Accounting break-even < Financial break-even (typically) Ignores time-value of money So NPV < 0 at accounting break-even level of sales What is the IRR? Lecture 8: Project Analysis and Evaluation 9 Cash Break-Even Analysis Level of sales that results in zero yearly cash flow OCF = { [Sales*3(1 0.1) 45,000 4,000]*(1-0.15) + 4,000} = 0 Sales = 16,405 Textbook General formula: Sales = FC/(Price var cost) But this ignores effect of taxes Cash break-even < Accounting break-even < Financial break-even Initial investment completely ignored NPV = -Investment IRR = -100% Cash Break-Even is useful for the treasurer/cash manager to determine working capital needs Lecture 8: Project Analysis and Evaluation 10 5

6 Operating Leverage Degree of Operating Leverage (DOL): The degree to which a change in sales affects Operating Cash Flow Can also be expressed as: the ratio of fixed costs to OCF DOL = 1 + FC/OCF Projects with high operating leverage have high fixed costs and low variable costs Intuition: In a project with high fixed costs and low variable costs, a change in the level of sales will have a large impact on OCF because revenues will increase while costs will stay steady. High operating leverage? riskier OCF Lever Lecture 8: Project Analysis and Evaluation 11 Leverage The Degree of Operating Leverage is often a choice of the firm. High DOL examples: Low DOL examples: A related concept is Financial Leverage : the degree to which changes in EBIT affect earnings. Financial leverage is higher for firms with higher debt loads Changes in revenues have greater effect on shareholders Resulting rate of return is riskier Operating leverage and financial leverage are chosen to compliment each other. Lecture 8: Project Analysis and Evaluation 12 6

7 Simulation Analysis Scenario analysis and sensitivity analysis are both very limited in their ability to reflect all the possible outcomes. Simulation analysis lets us describe possible values of the inputs in a much more complete way (often as random variables), and lets us vary many inputs at the same time. Too difficult to solve analytically Monte Carlo Simulations Sample the input variables many times, and each time calculate the NPV, then analyze the distribution of possible NPVs. Time consuming, so let the computer do it. Lecture 8: Project Analysis and Evaluation 13 Managerial Flexibility (Options) We have imagined the sole job of the manager as a yes/no then wait for the outcome. In reality, managers get the big bucks because they need to be constantly making decisions as the project progresses: Should we wait before deciding Should we expand/contract the project Should we switch inputs Should we abandon the project This flexibility increases the value (and hence the true NPV) of the project Lecture 8: Project Analysis and Evaluation 14 7

8 Valuing Managerial Flexibility Our basic DCF analysis cannot handle decisions made after a project is accepted, but all is not lost. Decision trees: Map out all the possible outcomes and the decisions that we will take in each case, and then value the resulting cash flows. Real Options: Use the techniques developed for financial options (call options, put options, etc), to value options on real assets. These techniques are very powerful and important, but they must await another course. Lecture 8: Project Analysis and Evaluation 15 What we know now DCF analysis is hard: cash flows are not certain. We have techniques for dealing with uncertainty: Scenario analysis: analyze different possible states of the world Sensitivity analysis: Change one input and see the results Break-even analysis: how far can we drop before the project is bad Degree of operating leverage: how are changes in cash flows reflected in earnings Simulation analysis: Allows more complete description of possible future risks Managerial flexibility increases the value of projects Capital rationing is a friction that sometimes prevents the use of DCF analysis Lecture 8: Project Analysis and Evaluation 16 8