B 1

How Firms Organize the Investment Process
Project Analysis
Stages in evaluating the firms investments:

The Capital
Budget
How Firms Organize the Investment

Process
Sensitivity Analysis
Scenario Analysis
Break-Even Analysis
Flexibility in Capital Budgeting
*Property of STI
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Stage 1
Stage 2
Source :http://campus.murraystate.edu
*Property of STI
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Project
Authorizations
Source: https://drupal.org/files/project-images/pass_phrase.jpg
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Project Authorization
The Capital Budget
Source: http://www.jjssoftware.co.uk
Source: http://www.zanebenefits.com
Investments required by law or company policy
Wish list is gathered and consolidated into one master list
Maintenance or cost reduction
The final approved budget becomes the basis for planning

during the coming year
Capacity expansion
*Property of STI
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Investment for new products

*Property of STI
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Challenges that firms face in valuing capital investment

opportunities:
Ensuring that forecasts are consistent
Eliminating conflict of interest
Source: http://blogs.rhsmith.umd.edu
Reducing forecast bias
Analysis of the effects of changes in sales, costs, and so on,

on a project profitability
Sorting the wheat from the chaff
Determine what else might happen and the effects of those

possible events
*Property of STI
I0040
Source: http://www.fuelyourventure.com/files/problems.jpg
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Financial forecast for this project:
Year 0
Case Study 1
Investment
You own a resort in Coron, Palawan called Travelers Haven.

During the past two years, you have experienced increased
occupancy especially during the peak months. In fact, during
summer, you have had to turn down several bookings
because you were full. Because of this, you are planning to
expand by constructing an additional building that will
increase your capacity by another 40%. You did some
analysis and you came up with a forecast.
Sales
P3,000,000
Variable Costs
1,800,000
Fixed Costs
500,000
Depreciation
250,000
Pretax Profit
450,000
Taxes (at 35%)
157,500
Profit after Tax
292,500
Cash Flow from Operations

Net Cash Flow
*Property of STI
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*Property of STI
Years 1 - 12
- P3,000,000
542,500
- P3,000,000
P 542,500
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Sensitivity Analysis for Travelers Haven:
Limits of Sensitivity Analysis

Range
NPV
Investment
Pessimistic Expected Optimistic Pessimistic Expected Optimistic

3,500,000 3,000,000 2,800,000 698,000 1,088,000 1,478,000
Sales
2,500,000 3,000,000 3,500,000 108,000 1,088,000 2,068,000
Variable Costs %
Fixed Costs
70%
60%
50%
-381,000 1,088,000 2,558,000
600,000
500,000
400,000
598,000 1,088,000 1,578,000
It gives somewhat ambiguous results
The variables are interrelated
Source: http://www.jrmooneyham.com
*Property of STI
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Scenario Analysis
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Scenario Analysis
Possible scenarios for Traveler's Haven: expansion of direct

competitor
A competing resort will reduce your projected sales by 15%

Source: http://www.fairfaxcounty.gov
As a result variable cost will be 65% of sales
Managers find it useful to analyze the projects performance

under different scenarios
A project analysis given a particular combination of
assumptions
*Property of STI
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Scenario Analysis
Break-Even Analysis
Cash Flows,
Cash Flows,
Years 1-12
Years 1-12
Base Case
Competitor
Sales
3,000,000
2,550,000
Variable Costs
1,800,000
1,657,500
Fixed Costs
500,000
500,000
Depreciation
250,000
250,000
Pretax Profit
450,000
142,500
Taxes
157,500
49,875
Profit After Tax
292,500
92,625
Cash Flow from Operations
542,500
342,625
PV of Cash Flows
4,088,280
2,582,022
NPV
1,088,280
-417,978
*Property of STI
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Break-Even Analysis
Source: http://thumbs.dreamstime.com
An analysis of the level of sales at which the company breaks

even
Break-even is the point where we are not making money but
we are also not losing money
*Property of STI
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Break-Even Analysis
Accounting Break-Even Analysis
Break-even is the point where profits are zero or where total

revenues are equal to total costs
NPV Break-Even Analysis
The focus is on the point when NPV switches from negative

to positive
Pretax Profit = Sales Variable Cost Fixed Cost Depreciation
Contribution Margin = Sales Variable Costs

Fixed Costs + Depreciation
Break-even level = -------------------------------------------Contribution Margin
*Property of STI
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Tax (@ %) = % of Pretax Profit

Profit after tax = Pretax profit - tax
Cash Flow = Profit after tax + Depreciation
PV Cash flow = Cash flows x 12 year annuity factor
*Property of STI
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Break-Even Analysis
Operating Leverage
Different flexibility injected by the managers in decision making:

Decision Tree
This pertains to the degree to

which costs are fixed
Option to Expand
A project with high fixed costs is

deemed more risky because a
decline in sales has a greater
effect
Abandonment Options
Flexible Production Facilities
Source: http://isifederal.com
Investment Timing Options

Source: http://deepbluesky.com
*Property of STI
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Decision Tree
*Property of STI
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*Property of STI
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How Firms Organize the Investment Process

Stages in evaluating the firms investments:

How Firms Organize the Investment

How Firms Organize the Investment Process

Investments required by law or company policy

Wish list is gathered and consolidated into one master list

Maintenance or cost reduction

The final approved budget becomes the basis for planning

Investment for new products

How Firms Organize the Investment Process

Challenges that firms face in valuing capital investment

Reducing forecast bias

Analysis of the effects of changes in sales, costs, and so on,

Sorting the wheat from the chaff

Determine what else might happen and the effects of those

You own a resort in Coron, Palawan called Travelers Haven.

Taxes (at 35%)

Profit after Tax

Cash Flow from Operations

Sensitivity Analysis for Travelers Haven:

Limits of Sensitivity Analysis

Pessimistic Expected Optimistic Pessimistic Expected Optimistic

2,500,000 3,000,000 3,500,000 108,000 1,088,000 2,068,000

-381,000 1,088,000 2,558,000

598,000 1,088,000 1,578,000

It gives somewhat ambiguous results

The variables are interrelated

Possible scenarios for Traveler's Haven: expansion of direct

A competing resort will reduce your projected sales by 15%

As a result variable cost will be 65% of sales

Managers find it useful to analyze the projects performance

Profit After Tax

Cash Flow from Operations

An analysis of the level of sales at which the company breaks

Accounting Break-Even Analysis

Break-even is the point where profits are zero or where total

NPV Break-Even Analysis

The focus is on the point when NPV switches from negative

Contribution Margin = Sales Variable Costs

Tax (@ %) = % of Pretax Profit

Flexibility in Capital Budgeting

Different flexibility injected by the managers in decision making:

This pertains to the degree to

A project with high fixed costs is

Investment Timing Options

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