Chapters Outline
Prepared by: Thomas J. Cottrell
Modified by: Carlos Vecino HEC-Montreal
Chapter 9
Net Present Value and Other Investment Criteria

9.1
Net Present Value
Chapter 10
Making Capital Investment Decisions

10.1 Project Cash Flows: A First Look

10.2 Incremental Cash Flows

10.3 Pro Forma Financial Statements and Project
Cash Flows
Chapter 11
Project Analysis and Evaluation

11.3
 11.4
 11.5
Irwin/McGraw-Hill
Break-Even Analysis
Operating Cash Flow, Sales Volume, and Break-Even
Operating Leverage
copyright © 2002 McGraw-Hill Ryerson, Ltd.
NPV Illustrated

Assume you have the following information on Project X:
Initial outlay -$1,100
Required return = 10%
Annual cash revenues and expenses are as follows:

Year
Revenues
Expenses
1
2
$1,000
2,000
$500
1,000
Draw a time line and compute the NPV of project X.
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 2
NPV Illustrated (concluded)
0
Initial outlay
($1,100)
1
Revenues
Expenses
$1,000
500
Cash flow
$500
– $1,100.00
$500 x
+454.55
2
Revenues
Expenses
Cash flow $1,000
1
1.10
$1,000 x
+826.45
$2,000
1,000
1
1.10 2
+$181.00 NPV
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 3
Underpinnings of the NPV Rule
 Why does the NPV rule work? And what does “work” mean?
Look at it this way:
A “firm” is created when securityholders supply the funds to acquire
assets that will be used to produce and sell a good or a service;
The market value of the firm is based on the present value of the
cash flows it is expected to generate;
Additional investments are “good” if the present value of the
incremental expected cash flows exceeds their cost;
Thus, “good” projects are those which increase firm value - or, put
another way, good projects are those projects that have positive
NPVs!
Moral of the story: Invest only in projects with positive NPVs.
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 4
Fundamental Principles of Project Evaluation
 Fundamental Principles of Project Evaluation:
Project evaluation - the application of one or more capital
budgeting decision rules to estimated relevant project cash
flows in order to make the investment decision.
Relevant cash flows - the incremental cash flows associated with
the decision to invest in a project.
The incremental cash flows for project evaluation consist
of any and all changes in the firm’s future cash flows that
are a direct consequence of taking the project.
Stand-alone principle - evaluation of a project based on the
project’s incremental cash flows.
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 5
Example: Preparing Pro Forma Statements
 Suppose we want to prepare a set of pro forma financial statements
for a project for Norma Desmond Enterprises. In order to do so, we
must have some background information. In this case, assume:
1. Sales of 10,000 units/year @ $5/unit.
2. Variable cost per unit is $3. Fixed costs are $5,000 per year.
The project has no salvage value. Project life is 3 years.
3. Project cost is $21,000. Depreciation is $7,000/year.
4. Additional net working capital is $10,000.
5. The firm’s required return is 20%. The tax rate is 34%.
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 6
Example: Preparing Pro Forma Statements (continued)
Pro Forma Financial Statements
Projected Income Statements
Sales
Var. costs
$______
______
$20,000
Fixed costs
5,000
Depreciation
7,000
EBIT
Taxes (34%)
Net income
$______
2,720
$______
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 7
Example: Preparing Pro Forma Statements (continued)
Pro Forma Financial Statements
Projected Income Statements
Sales
Var. costs
$50,000
30,000
$20,000
Fixed costs
5,000
Depreciation
7,000
EBIT
Taxes (34%)
Net income
$ 8,000
2,720
$ 5,280
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 8
Example: Preparing Pro Forma Statements (concluded)
Projected Balance Sheets
0
1
2
3
$______
$10,000
$10,000
$10,000
NFA
21,000
______
______
0
Total
$31,000
$24,000
$17,000
$10,000
NWC
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 9
Example: Preparing Pro Forma Statements (concluded)
Projected Balance Sheets
0
1
2
3
NWC
$10,000
$10,000
$10,000
$10,000
NFA
21,000
14,000
7,000
0
Total
$31,000
$24,000
$17,000
$10,000
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 10
Example: Using Pro Formas for Project Evaluation
 Now let’s use the information from the previous example to do
a capital budgeting analysis.
Project operating cash flow (OCF):
EBIT
$8,000
Depreciation
+7,000
Taxes
-2,720
OCF
$12,280
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 11
Example: Using Pro Formas for Project Evaluation (continued)
 Project Cash Flows
0
OCF
Chg. NWC
______
Cap. Sp.
-21,000
Total
______
1
2
3
$12,280
$12,280
$12,280
______
$12,280
$12,280
$______
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 12
Example: Using Pro Formas for Project Evaluation (continued)
 Project Cash Flows
0
OCF
Chg. NWC
-10,000
Cap. Sp.
-21,000
Total
-31,000
1
2
3
$12,280
$12,280
$12,280
10,000
$12,280
$12,280
$22,280
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 13
Example: Using Pro Formas for Project Evaluation (concluded)
 Capital Budgeting Evaluation:
NPV
=
=
-$31,000 + $12,280/1.201 + $12,280/1.20 2 + $22,280/1.20 3
$655
IRR
=
21%
Should the firm invest in this project? Why or why not?
Yes -- the NPV > 0, and the IRR > required return
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 14
Evaluating NPV Estimates
I: The Basic Problem
 The basic problem: How reliable is our NPV estimate?

Projected vs. Actual cash flows
Estimated cash flows are based on a distribution of possible
outcomes each period

Forecasting risk
The possibility of a bad decision due to errors in cash flow
projections - the GIGO phenomenon

Sources of value
What conditions must exist to create the estimated NPV?
“What If” analysis
A.
Scenario analysis
B.
Sensitivity analysis
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 15
Evaluating NPV Estimates
II: Scenario and Other “What-If” Analyses
 Scenario and Other “What-If” Analyses

“Base case” estimation
Estimated NPV based on initial cash flow projections

Scenario analysis
Posit best- and worst-case scenarios and calculate NPVs

Sensitivity analysis
How does the estimated NPV change when one of the input
variables changes?

Simulation analysis
Vary several input variables simultaneously, then construct a
distribution of possible NPV estimates
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 16
T11.12 Summary of Break-Even Measures (Table 11.1)
I.
The General Expression
Q = (FC + OCF)/(P - V)
where:
FC = total fixed costs
P = Price per unit
v = variable cost per unit
II. The Accounting Break-Even Point
Q = (FC + D)/(P - V)
At the Accounting BEP, net income = 0, NPV is negative, and IRR of 0.
III. The Cash Break-Even Point
Q = FC/(P - V)
At the Cash BEP, operating cash flow = 0, NPV is negative, and IRR = -100%.
IV. The Financial Break-Even Point
Q = (FC + OCF*)/(P - V)
At the Financial BEP, NPV = 0 and IRR = required return.
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 17
Fairways Driving Range Example
 Fairways Driving Range expects rentals to be 20,000 buckets at $3 per
bucket. Equipment costs $20,000 and will be depreciated using SL over 5
years and have a $0 salvage value. Variable costs are 10% of rentals and
fixed costs are $40,000 per year. Assume no increase in working capital nor
any additional capital outlays. The required return is 15% and the tax rate is
15%.
Revenues
Variable costs
$60,000
6,000
Fixed costs
40,000
Depreciation
4,000
EBIT
Taxes (@15%)
Net income
$10,000
1500
$ 8,500
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 18
Fairways Driving Range Sensitivity Analysis
INPUTS FOR SENSITIVITY ANALYSIS
 Base case: Rentals are 20,000 buckets, variable costs
are 10% of revenues, fixed costs are $40,000,
depreciation is $4,000 per year, and the tax
rate is 15%.
 Best case: Rentals are 25,000 buckets and revenues are
$75,000. All other variables are unchanged.
 Worst case: Rentals are 18,000 buckets and revenues are
$54,000. All other variables are unchanged.
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 19
T11.6 Fairways Driving Range Sensitivity Analysis (concluded)
Revenues
Net
income
Project
cash flow
NPV
$19,975
$23,975
$60,364
Scenario
Rentals
Best case
25,000
$75,000
Base case
20,000
60,000
8,500
12,500
21,900
Worst case
18,000
54,000
3,910
7,910
6,514
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 20
Fairways Driving Range: Rentals vs. NPV
Fairways Sensitivity Analysis - Rentals vs. NPV
NPV
Best case
$60,000
NPV = $60,035
x
Base case
NPV = $21,900
x
Worst case
0
NPV = $3,437
x
-$60,000
15,000
20,000
25,000
Rentals per Year
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 21
Fairways Driving Range: Total Cost Calculations
 Total Cost = Variable cost + Fixed cost
Rentals
0
Variable
Revenue
cost
$0
Fixed
cost
$0
$40,000
Total
cost
Depr.
$40,000 $4,000
Total
acct. cost
$44,000
15,000
45,000
4,500
40,000
44,500
4,000
48,500
20,000
60,000
6,000
40,000
46,000
4,000
50,000
25,000
75,000
7,500
40,000
47,500
4,000
51,500
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 22
Fairways Driving Range: Break-Even Analysis
Fairways Break-Even Analysis - Sales vs. Costs and Rentals
Total revenues
$80,000
Accounting
break-even point
16,296 Buckets
$50,000
Fixed costs + Dep
$44,000
Net
Net
Income < 0
Income > 0
$20,000
15,000
20,000
25,000
Rentals per Year
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 23
Fairways Driving Range: Accounting Break-Even Quantity
 Fairways Accounting Break-Even Quantity (Q)
Q = (Fixed costs + Depreciation)/(Price per unit - Variable cost per unit)
= (FC + D)/(P - V)
= ($40,000 + 4,000)/($3.00 - .30)
= 16,296 buckets
If sales do not reach 16,296 buckets, the firm will incur losses in both the
accounting sense and the financial sense .
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 24
Operating Leverage
Basic Idea: “Operating Leverage” is the degree to which a
project or a firm relies on fixed production costs.
Measuring Operating Leverage: If the quantity sold rises by X%,
what will be the percentage change in operating cash flow?
This percentage change (%) in Operating Cash Flow (OCF) is
called the Degree of Operating Leverage (DOL).
Percentage change (%) in OCF = DOL x Percentage change (%) in Q
DOL = 1 + (Fixed Costs / OCF)
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 25
Fairways Driving Range DOL

Since % in OCF = DOL  %  in Q, DOL is a “multiplier” which
measures the effect of a change in quantity sold on OCF.

For Fairways, let Q = 20,000 buckets. Ignoring taxes,
OCF = $14,000 and fixed costs = $40,000, and
Fairway’s DOL = 1 + FC/OCF = 1 + $40,000/$14,000 = 3.857.
In other words, a 10% increase (decrease) in quantity sold will result in
a 38.57% increase (decrease) in OCF.

Two points should be kept in mind:


Higher DOL suggests greater volatility (i.e., risk) in OCF;
Leverage is a two-edged sword - sales decreases will be magnified as
much as increases.
FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd
Slide 26