Project Analysis

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Chapter 8

Project Analysis (??????)
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Topics Covered

• How Firms Organize Their Investment Process
• Some What If Questions
• Sensitivity Analysis
• Break Even Analysis
• Flexibility in Capital Budgeting
• Decision Trees
• Options

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Capital Budgeting Process

• Capital Budget - The list of planned investment
  projects.
• The Decision Process
• 1 - Develop and rank all investment projects
• 2 - Authorize projects based on
• Government regulation or law
• Production efficiency
• Capacity requirements
• NPV

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Capital Budgeting Process

• Capital Budgeting Problems
• Consistent forecasts (??????????)
• Conflict of interest
• (????????????????)
• Forecast bias
• (?????????????????)
• Selection criteria (NPV and others)

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How To Handle Uncertainty

• Sensitivity Analysis - Analysis of the effects of
  changes in sales, costs, etc. on a project.
• Scenario Analysis - Project analysis given a
  particular combination of assumptions.
• Simulation Analysis - Estimation of the
  probabilities of different possible outcomes.
• Break Even Analysis - Analysis of the level of
  sales (or other variable) at which the company
  breaks even (Accounting vs. NPV break-even)

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Sensitivity Analysis (?????)

• Example
• Given the expected cash flow forecasts listed on
  the next slide, determine the NPV of the project
  given changes in the cash flow components using
  an 8 cost of capital. Assume that all variables
  remain constant, except the one you are changing.

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Sensitivity Analysis

• Example - continued

NPV 478
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Sensitivity Analysis

• Example - continued
• Possible Outcomes

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Sensitivity Analysis

• Example - continued
• NPV Calculations for Pessimistic Investment
  Scenario

NPV (121)
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Sensitivity Analysis

• Example continued
• NPV Possibilities
• (Check out the values! Some of them are wrong)

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??
????????
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Break Even Analysis (??????)

• Example
• Given the forecasted data on the next slide,
  determine the number of planes that the company
  must produce in order to break even, on an NPV
  basis. The companys cost of capital is 10.

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Break Even Analysis
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Break Even Analysis

• Answer
• The break even point, is the of Planes Sold
  that generates a NPV0.
• The present value annuity factor of a 6 year
  cash flow at 10 is 4.355
• Thus,

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Break Even Analysis
Answer Solving for Planes Sold
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Operating Leverage (????)

• Operating Leverage- The degree to which costs
  are fixed.
• Degree of Operating Leverage (DOL) - Percentage
  change in profits given a 1 percent change in
  sales.

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Operating Leverage

• Example - A company has sales outcomes that range
  from 16mil to 19 mil, Depending on the economy.
  The same conditions can produce profits in the
  range from 550,000 to 1,112,000. What is the
  DOL?

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Flexibility Options

• Decision Trees - Diagram of sequential decisions
  and possible outcomes.
• Decision trees help companies determine their
  Options by showing the various choices and
  outcomes.
• The Option to avoid a loss or produce extra
  profit has value.
• The ability to create an Option thus has value
  that can be bought or sold.

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Decision Trees
Success
Test (Invest 200,000)
Pursue project NPV2million
Failure
Stop project NPV0
Dont test
NPV0
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Decision Trees

• Allow us to graphically represent the
  alternatives available to us in each period and
  the likely consequences of our actions.
• This graphical representation helps to identify
  the best course of action.

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Example of Decision Tree
Squares represent decisions to be made.
Good
Circles represent receipt of information e.g. a
test score.
Test Market
OK
Failure
The lines leading away from the squares represent
the alternatives.
Do not Test
D
F
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Stewart Pharmaceuticals

• The Stewart Pharmaceuticals Corporation is
  considering investing in developing a drug that
  cures the common cold.
• A corporate planning group, including
  representatives from production, marketing, and
  engineering, has recommended that the firm go
  ahead with the test and development phase.
• This preliminary phase will last one year and
  cost 1 billion. Furthermore, the group believes
  that there is a 60 chance that tests will prove
  successful.
• If the initial tests are successful, Stewart
  Pharmaceuticals can go ahead with full-scale
  production. This investment phase will cost 1.6
  billion. Production will occur over the next 4
  years.

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Stewart Pharmaceuticals NPV of Full-Scale
Production following Successful Test

• Note that the NPV is calculated as of date 1, the
  date at which the investment of 1,600 million is
  made. Later we bring this number back to date 0.

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Stewart Pharmaceuticals NPV of Full-Scale
Production following Unsuccessful Test

• Note that the NPV is calculated as of date 1, the
  date at which the investment of 1,600 million is
  made. Later we bring this number back to date 0.

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Decision Tree for Stewart Pharmaceutical
60 chance
40 failure
Now Date0
Date1
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Stewart Pharmaceutical Decision to Test

• Lets move back to the first stage, where the
  decision boils down to the simple question
  should we invest?
• The expected payoff evaluated at date 1 is

The NPV evaluated at date 0 is
So we should test.
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Options

• One of the fundamental insights of modern finance
  theory is that options have value.
• The phrase We are out of options is surely a
  sign of trouble.
• Because corporations make decisions in a dynamic
  environment, they have options that should be
  considered in project valuation.

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What is Real Option Analysis?

• Real options exist when managers can influence
  the size and riskiness of a projects cash flows
  by taking different actions during the projects
  life.
• Real option analysis incorporates typical NPV
  budgeting analysis with an analysis for
  opportunities resulting from managers decisions.

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Real Options

• The Option to Expand/Growth
• Has value if demand turns out to be higher than
  expected.
• The Option to Abandon/shutdown
• Has value if demand turns out to be lower than
  expected.
• The Option to Delay/Investment timing options
• Has value if the underlying variables are
  changing with a favorable trend.

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Discounted Cash Flows and Options

• We can calculate the market value of a project as
  the sum of the NPV of the project without options
  and the value of the managerial options implicit
  in the project.
• M NPV Real Option
• A good example would be comparing the
  desirability of a specialized machine versus a
  more versatile machine. If they both cost about
  the same and last the same amount of time the
  more versatile machine is more valuable because
  it comes with options.

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The Option to Abandon Example

• Suppose that we are drilling an oil well. The
  drilling rig costs 300 today and in one year the
  well is either a success or a failure.
• The outcomes are equally likely. The discount
  rate is 10.
• The PV of the successful payoff at time one is
  575.
• The PV of the unsuccessful payoff at time one is
  0.

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The Option to Abandon Example
Traditional NPV analysis would indicate rejection
of the project.
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The Option to Abandon Example
Traditional NPV analysis overlooks the option to
abandon.
Success PV 575
Sit on rig stare at empty hole PV 0.
Drill
-
300

Failure
Sell the rig salvage value 250
Do not drill
The firm has two decisions to make drill or not,
abandon or stay.
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The Option to Abandon Example
When we include the value of the option to
abandon, the drilling project should proceed
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Valuation of the Option to Abandon

• Recall that we can calculate the market value of
  a project as the sum of the NPV of the project
  without options and the value of the managerial
  options implicit in the project.
• M NPV Opt
• 75.00 38.61 Opt
• 75.00 38.61 Opt
• Opt 113.64

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Illustrating an Investment Timing Option

• If we proceed with Project L, its annual cash
  flows are 33,500, and its NPV is 6,190.
• However, if we wait one year, we will find out
  some additional information regarding output
  prices and the cash flows from Project L.
• If we wait, the up-front cost will remain at
  100,000 and there is a 50 chance the subsequent
  CFs will be 43,500 a year, and a 50 chance the
  subsequent CFs will be 23,500 a year.

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Investment Timing Decision Tree
-100,000 43,500 43,500 43,500
43,500
50 prob.
-100,000 23,500 23,500 23,500
23,500
50 prob.
0 1 2 3 4
5
Years

• At k 10, the NPV at t 1 is
• 37,889, if CFs are 43,500 per year, or
• -25,508, if CFs are 23,500 per year, in which
  case the firm would not proceed with the project.

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Should We Wait or Proceed?

• If we proceed today, NPV 6,190.
• If we wait one year, Expected NPV at t 1 is
  0.5(37,889) 0.5(0) 18,944.57, which is
  worth 18,944.57 / (1.10) 17,222.34 in todays
  dollars (assuming a 10 discount rate).
• Therefore, it makes sense to wait.

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Issues to Consider with Investment Timing Options

• Whats the appropriate discount rate?
• Note that increased volatility makes the option
  to delay more attractive. For example
• If instead, there was a 50 chance the subsequent
  CFs will be 53,500 a year, and a 50 chance the
  subsequent CFs will be 13,500 a year, expected
  NPV next year (if we delay) would be
• 0.5(69,588) 0.5(0) 34,794 gt
  18,944.57
• 34,794/1.131631gt17222gt6190

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Factors to Consider When Deciding When to Invest

• Delaying the project means that cash flows come
  later rather than sooner.
• It might make sense to proceed today if there are
  important advantages to being the first
  competitor to enter a market.
• Waiting may allow you to take advantage of
  changing conditions.