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ADVANCE-Managerial Finance Class Notes for Chapter 11 D.B. Hammupdated Jan. 2006
Basic ProblemHow reliable is our NPV estimate for new project(s) under consideration?
Projected vs. actual cash flows Forecasting riskpossibility that errors in projected cash flows will lead to incorrect decisions Also called estimation risk (same)
Scenario analysis
Ask basic What if? questions and rework NPV estimates Worst casegood start pointwhat is the minimum NPV for the project? Best caseupper limit bound of project NPV Base casemost likely outcome assumed (probably some midpoint between best & worst)
Sensitivity analysis
Impact on NPV and/or IRR when one variable is changed (up or down) and other variables remain at base case If our estimate of NPV or IRR is very sensitive (changes significantly) to relatively small changes in some component, forecasting risk for that variable is high
Simulation analysis
Combine scenario and sensitivity analysis to calculate impact of varying changes Use of a computer (spreadsheet or other software) is essential Still may be impossible to forecast every possible combination of variables, but should give us some trends
Illustration:
Wally's Widget Works New Project Estimate Unit Sales x Selling price per unit Sales Revenue -Variable Costs at $8 per unit Contribution Margin - Fixed costs (other than depr.) - Depreciation EBIT Taxes @ 40% Net Income OCF (EBIT+ Depr-Taxes) Pres. Value (4 yrs x above at 12%) Less Original Investment NPV IRR Base 6,000 $15 $90,000 -$48,000 $42,000 -$12,000 -$11,000 $19,000 -$7,600 $11,400 $22,400 $68,037 -$60,000 $8,037 18.22% Scenario Worst 4,500 $15 $67,500 -$36,000 $31,500 -$12,000 -$11,000 $8,500 -$3,400 $5,100 $16,100 $48,901 -$60,000 ($11,099) 2.89% Best 7,500 $15 $112,500 -$60,000 $52,500 -$12,000 -$11,000 $29,500 -$11,800 $17,700 $28,700 $87,172 -$60,000 $27,172 32.15%
Once our template is set up we may rerun with any variations required
TC = VC + FC + D
Or S = v x Q + FC+D
at break even point (accounting break even) Accounting break even occurs where net income from project = 0
Therefore S VC FC D = 0
Since S VC FC D = 0 at break even And since S = p x Q (selling price x quantity) And VC = v x Q (vc per unit x Q) Then (p x Q)-(v x Q) FC D = 0 Finally accounting break even quantity is: Q = FC + D
p -v
Q = 8,889 units
Q = 6,667 units
Note: B/E quantity for cash flow is less than required for accounting break even, but project at cash b/e only can never pay back its original investment. IRR = -100%
pv
*Where OCF results in a zero NPV
Operating Leverage
Operating leverage is the degree to which a project relies on fixed costs Degree of operating leverage = % change in OCF relative to % change in quantity sold DOL = 1 + (FC/OCF)