Project Analysis

and Evaluation
 Capital Budgeting
Techniques
• Net Present Value (NPV)
• Payback Period
• Discounted Payback Period
• Average Accounting Return
• Internal Rate of Return (IRR)
• Profitability Index (PI)

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 Project Cash Flows

• Net Capital Spending.

• Net operating cash flows.
• Change in Net Working Capital
 Operating Cash flows
• Cash Flows from Operations
Operating Cash Flow = EBIT – Taxes +
Depreciation
Operating Cash Flow = Sales – Costs – Taxes
Operating Cash Flow = Net Income +Depreciation
Operating Cash Flow = (Sales – Costs)*(1-T) +
Dep. *T
 Evaluating NPV Estimates
• NPV estimates are just that – estimates
• A positive NPV is a good start – now we
need to take a closer look
– Forecasting risk – how sensitive is our NPV to
changes in the cash flow estimates; the more
sensitive, the greater the forecasting risk

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 Net Present Value (NPV)
• Net Present Value (NPV). Net Present Value is found
by subtracting the present value of the after-tax
outflows from the present value of the after-tax
inflows.
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, indifferent
 Net Present Value
• NPV = CF0 + CF1 + CF2 + . . . + CFn

(1+R) (1+R)^2
(1+R)^n

CFn is the expected net cash flow at

period n
R is the project’s cost of capital
n is the life of the project
 Internal Rate of Return (IRR)
The IRR is the discount rate that will equate the present value
of the outflows with the present value of the inflows:

The IRR is the project’s intrinsic rate of return.

Decision Criteria
If IRR > R, accept the project
If IRR < R, reject the project
If IRR = R, indifferent
 Internal Rate of Return
(IRR)
• NPV=0 = CF0 + CF1 + CF2 + . . . + CFn
(1+IRR) (1+IRR)^2 (1+IRR)^n

CFn is the expected net cash flow at period n

IRR is the project’s internal rate of return
n is the life of the project
 Project Example Information

• You are looking at a new project and you

have estimated the following cash flows:
– Year 0: CF = -165,000
– Year 1: CF = 63,120
– Year 2: CF = 70,800
– Year 3: CF = 91,080
• Your required return for assets of this risk is
12%.
 Scenario Analysis
• What happens to the NPV under different
cash flow scenarios?
• At the very least, look at:
– Best case – high revenues, low costs
– Worst case – low revenues, high costs
– Measure of the range of possible outcomes

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 New Project Example
• Consider the project:
• The initial cost is $200,000, and the project has a
5-year life. There is no salvage. Depreciation is
straight-line, the required return is 12%, and the
tax rate is 34%.
Base case Lower Bound Upper Bound
Unit sales 6,000 5,500 6,500
Price per unit 80 75 85
Variable costs per
unit 60 58 62
Fixed costs per year 50,000 45,000 55,000
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 Summary of Scenario
Analysis
Scenario Net Income Cash Flow NPV IRR

Base case 19,800 59,800 15,567 15.1%

Worst Case -15,510 24,490 -111,719 -14.4%

Best Case 59,730 99,730 159,504 40.9%

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 Sensitivity Analysis
• What happens to NPV when we change
one variable at a time
• This is a subset of scenario analysis
where we are looking at the effect of
specific variables on NPV
• The greater the volatility in NPV in
relation to a specific variable, the larger
the forecasting risk associated with that
variable, and the more attention we want
to pay to its estimation

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 Summary of Sensitivity Analysis
for New Project
Scenario Unit Sales Cash Flow NPV IRR

Base case 6,000 59,800 15,567 15.1%

Worst case 5,500 53,200 -8,226 10.3%

Best case 6,500 66,400 39,357 19.7%

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 Simulation Analysis
• Simulation is combination of Scenario and
Sensitivity analysis

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 Making a Decision
• Beware “Paralysis of Analysis”
• At some point you have to make a decision
• If the majority of your scenarios have
positive NPVs, then you can feel
reasonably comfortable about accepting the
project
• If you have a crucial variable that leads to a
negative NPV with a small change in the
estimates, then you may want to forego the
project

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 Break-Even Analysis
• Common tool for analyzing the relationship
between sales volume and profitability
• There are three common break-even
measures
– Accounting break-even – sales volume at which
NI = 0
– Cash break-even – sales volume at which OCF
=0
– Financial break-even – sales volume at which
NPV = 0

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 Accounting Break-Even
• The quantity that leads to a zero net
income
• NI = (Sales – VC – FC – D)(1 – T) =
0
• QP – vQ – FC – D = 0
• Q(P – v) = FC + D
• Q = (FC + D) / (P – v)

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 Using Accounting Break-
Even
• Accounting break-even is often used
as an early stage screening number
• If a project cannot break-even on an
accounting basis, then it is not going
to be a worthwhile project
• Accounting break-even gives
managers an indication of how a
project will impact accounting profit

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Accounting Break-Even and
Cash Flow
• We are more interested in cash flow than we are in
accounting numbers
• As long as a firm has non-cash deductions, there
will be a positive cash flow
• If a firm just breaks even on an accounting basis,
cash flow = depreciation
• If a firm just breaks even on an accounting basis,
NPV will generally be < 0

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 Example
• Consider the following project
– A new product requires an initial investment of
$5 million and will be depreciated to an
expected salvage of zero over 5 years
– The price of the new product is expected to be
$25,000, and the variable cost per unit is
$15,000
– The fixed cost is $1 million
– What is the accounting break-even point each
year?
• Depreciation = 5,000,000 / 5 = 1,000,000
• Q = (1,000,000 + 1,000,000)/(25,000 –
15,000) = 200 units
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 Sales Volume and
Operating Cash Flow
• What is the operating cash flow at the accounting
break-even point (ignoring taxes)?
– OCF = (S – VC – FC - D) + D
– OCF = (200*25,000 – 200*15,000 – 1,000,000 -1,000,000)
+ 1,000,000 = 1,000,000
• What is the cash break-even quantity?
– OCF = [(P-v)Q – FC – D] + D = (P-v)Q – FC
– Q = (OCF + FC) / (P – v)
– Q = (0 + 1,000,000) / (25,000 – 15,000) = 100 units

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 Example: Break-Even
Analysis
• Consider the previous example
– Assume a required return of 18%
– Accounting break-even = 200
– Cash break-even = 100
– What is the financial break-even point?
• What OCF (or payment) makes NPV = 0?
– N = 5; PV = 5,000,000; I/Y = 18; CPT PMT =
1,598,889 = OCF
• Q = (1,000,000 + 1,598,889) / (25,000 – 15,000) =
260 units
• The question now becomes: Can we sell
at least 260 units per year?

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 Three Types of Break-Even
Analysis
• Accounting Break-even
– Where NI = 0
– Q = (FC + D)/(P – v)
• Cash Break-even
– Where OCF = 0
– Q = (FC + OCF)/(P – v) (ignoring taxes)
• Financial Break-even
– Where NPV = 0
• Cash BE < Accounting BE < Financial BE

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 Operating Leverage
• Operating leverage is the relationship
between sales and operating cash flow
• Degree of operating leverage measures
this relationship
– The higher the DOL, the greater the variability
in operating cash flow
– The higher the fixed costs, the higher the DOL
– DOL depends on the sales level you are
starting from
• DOL = 1 + (FC / OCF)

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 Example: DOL
• Consider the previous example
• Suppose sales are 300 units
– This meets all three break-even measures
– What is the DOL at this sales level?
– OCF = (25,000 – 15,000)*300 – 1,000,000 =
2,000,000
– DOL = 1 + 1,000,000 / 2,000,000 = 1.5
• What will happen to OCF if unit sales
increases by 20%?
– Percentage change in OCF = DOL*Percentage
change in Q
– Percentage change in OCF = 1.5(.2) = .3 or 30%
– OCF would increase to 2,000,000(1.3) = 2,600,000

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