CORPORATE FINANCEIII
ESCP-EAP - European Executive MBA
24 Nov. 2005 a.m. London
Project Appraisal-Dealing with uncertainty
I. Ertürk
Senior Fellow in Banking
INNOVATION LTD
Project Appraisal
Identifying Relevant Cash flows
Use cash flows only not accounting figures Depreciation is not a cash flow but capital expenditure is Construct “Project Appraisal Table” Use incremental cash flows only Separate investment and financing decisions Include all incidental effects. Do not forget working capital requirements. Forget sunk costs. Include opportunity costs. Beware of allocated overhead costs Use after-tax cash flows only
INNOVATION LTD.
INVESTMENT APPRAISAL SCHEDULE
Year 0 1 2 3 4 5 6
Machinery -20,000 4,915
Grant 5,000
Sales revenue 65,000 87,500 100,000 100,000 100,000
Total cash costs -58,000 -77,000 -88,000 -88,000 -88,000
Opportunity cost of off-cuts -3,500 -4,500 -5,000 -5,000 -5,000
Tax paid -2,000 -4,050 -5,040 -5,232 -5,386
Tax saved 1,750 2,250 2,500 2,500 2,500
Net cash flow -20,000 8,500 5,750 5,200 4,460 4,268 2,030
Discount factors @ 10% 1 0.909 0.826 0.751 0.683 0.621 0.564
Present values (20000) 7727 4752 3907 3046 2650 1146
Net present value @ 10% 3,228
Internal rate of return 17%
Years 0 1 2 3 4 5 6
Payback 3.14 -20,000 -11,500 -5,750 -550 3,910Discounted payback 4.27 (20000) (12273) (7521) (3614) (568) 2083
INNOVATION LTD.PROFIT & LOSS ACCOUNT
Year 1 2 3 4 5
Sales Revenue 65,000 87,500 100,000 100,000 100,000
ExpenditureMaterials 2,000 2,000 2,000 2,000 2,000Labour 52,000 70,000 80,000 80,000 80,000Overheads 3,000 4,000 5,000 5,000 5,000Lease 1,000 1,000 1,000 1,000 1,000
Total cash costs 58,000 77,000 88,000 88,000 88,000
Non-cash: depreciation 3,000 2,400 1,920 1,536 1,229
Total expenditure 61,000 79,400 89,920 89,536 89,229
Net profit before tax 4,000 8,100 10,080 10,464 10,771
Tax 2,000 4,050 5,040 5,232 5,386
Net profit after tax 2,000 4,050 5,040 5,232 5,386
INNOVATION LTD.DEPRECIATION SCHEDULE
Cost 20,000Less Grant 5,000
Depreciable value 15,000
Year 1 - Depreciation @ 20% 3,000 Net book value 12,000
Year 2 - Depreciation @ 20% 2,400 Net book value 9,600
Year 3 - Depreciation @ 20% 1,920 Net book value 7,680
Year 4 - Depreciation @ 20% 1,536 Net book value 6,144
Year 5 - Depreciation @ 20% 1,229 Net book value 4,915
(DISCOUNTED) PAYBACK
INTERNAL RATE OF RETURN
PROFITABILITY INDEX
ALTERNATIVES TO THE NPV RULE
IF FIRM USES 1 YEAR CUTOFF PERIOD , ACCEPT PROJECT A
IF FIRM USES 2 YEAR CUTOFF PERIOD, ACCEPT PROJECTS A & B
REGARDLESS OF CUTOFF PERIOD, PAYBACK RULE MAY GIVE DIFFERENT ANSWER THAN NPV PAYBACK GIVES EQUAL WEIGHT TO ALL CASH FLOWS BEFORE
PAYBACK DATE AND NO WEIGHT TO LATER CASH FLOWS
NO DISCOUNTING - IGNORES TIME VALUE OF MONEY
NO GOOD RATIONALE FOR CUTOFF
PAY BACK RULE
CASH FLOWS (€000) NPV
Year: 0 1 2 3 Payback At 10%
B -2 +1 +1 +5 2 +3.492
C -2 +0 +2 +5 2
+3.409
D -2 +1 +1 +100 2
+74.867
PAY BACK RULE
CALCULATE LENGTH OF TIME UNTIL THE SUM OF THE DISCOUNTED CASH FLOWS IS EQUAL TO THE INITIAL INVESTMENT
ACCEPT PROJECT IF IT IS LESS THAN SOME CUTOFF VALUE
DISCOUNTED-PAYBACK RULE ASKS HOW LONG WILL IT BE UNTIL THE PROJECT HAS A POSITIVE NPV
NO LONGER GIVES EQUAL WEIGHT TO ALL CASH FLOWS BEFORE PAYBACK DATE BUT STILL IGNORES CASH FLOWS AFTER CUTOFF DATE
CANNOT BE USED FOR RANKING PROJECTS
DISCOUNTED PAY BACK RULE
INITIAL INVESTMENTPROFITABILITY INDEX = NET PRESENT VALUE
PROJECT INVESTMENT NPV PROFITABILITY INDEX
A 10 21 2.1
B 5 16 3.2
C 5 12 2.4
RANK PROJECTS IN TERMS OF DECLINING PICONTINUE MAKING INVESTMENTS UNTIL
CAPITAL EXHAUSTEDACCEPT PROJECTS B AND C
CAPITAL RATIONING
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.
Sensitivity AnalysisExample
Given the expected cash flow forecasts for Otobai Company’s Motor Scooter project, listed on the next slide, determine the NPV of the project given changes in the cash flow components using a 10% cost of capital. Assume that all variables remain constant, except the one you are changing.
Sensitivity Analysis
315- FlowCashNet
3.0flow cash Operating
1.5after taxProfit
1.550% @ .Taxes
3profitPretax
1.5onDepreciati
3Costs Fixed
30Costs Variable
37.5Sales
15-Investment
10-1 Years0Year
Example - continued
NPV= 3.43 billion Yen
Sensitivity AnalysisExample - continued
Possible Outcomes
bil 2bil 3bil 4Cost Fixed
275,000300,000360,000CostVar Unit
380,000375,000350,000priceUnit
.16.1.04ShareMarket
mil 1.1mil 1.0mil .9SizeMarket
OptimisticExpectedcPessimistiVariable
Range
Sensitivity AnalysisExample - continuedNPV Calculations for Optimistic Market Size Scenario
NPV= +5.7 bil yen
3.3815- FlowCashNet
3.38flow cash Operating
1.88after taxProfit
1.8850% @ .Taxes
3.75profitPretax
1.5onDepreciati
3Costs Fixed
33Costs Variable
41.25Sales
15-Investment
10-1 Years0Year
Sensitivity AnalysisExample - continued
NPV Possibilities (Billions Yen)
6.53.40.4Cost Fixed
11.13.415.0-CostVar Unit
5.03.44.2-priceUnit
17.33.410.4-ShareMarket
5.73.41.1SizeMarket
OptimisticExpectedcPessimistiVariable
Range
Break Even Analysis
Point at which the NPV=0 is the break even point
Otobai Motors has a breakeven point of 85,000 units sold.
Sales, 000’s
PV (Yen)
Billions
400
200
19.6
85 200
Break even
NPV=0
PV Inflows
PV Outflows
Electric Scooter – NPV
Cash Flows, Years 1-10, Billions
Base CaseHigh Oil Prices and
Recession Case
1 Revenue 37.5 44.9 2 Variable cost 30.0 35.9 3 Fixed cost 3.0 3.5 4 Depreciation 1.5 1.5 5 Pretax profit (1-2-3-4) 3.0 4.0 6 Tax 1.5 2.0 7 Net profit (5-6) 1.5 2.0 8 Net cash flow (4+7) 3.0 3.5
18.4 21.5 NPV 3.4 6.5
PV of cash flows
Electric Scooter - Assumptions
Base CaseHigh Oil Prices and
Recession CaseMarket size 1 million .8 million
Market share 0.1 0.13Unit Price 375000 431300
Unit variable cost 300000 345000Fixed cost 3 billion 3.5 billion
Assumptions
Electric Scooter - Scenarios
InflowsYear 0
Unit Sales, Thousands
Revenue, Years 1-10 Investment
Variable Costs
Fixed Costs Taxes PV Inflows
PV Outflows NPV
0 0 15 0 3 -2.25 0 19.6 -19.6100 37.5 15 30 3 1.5 230.4 227 3.4200 75 15 60 3 5.25 460.8 434.4 26.4
OutflowsYears 1-10
Electric Scooter – Accounting Profit
Unit Sales, Thousands Revenue
Variable Costs
Fixed Costs Depreciation Taxes
Total Costs
Profit after Tax
0 0 0 3 1.5 -2.25 2.25 -2.25100 37.5 30 3 1.5 1.5 36 1.5200 75 60 3 1.5 5.25 69.75 5.25
Electric Scooter – Cash Flows
Year 0 Year 1-10
Investment 15.00 1. Revenue 37.50 2. Variable cost 12.00 3. Fixed cost 19.00 4. Depreciation 1.50
5. Pretax profit (1-2-3-4) 5.00 6.Tax 2.50 7. Net profit (5-6) 2.50
8. Operating cash flow (4+7) 4.00
Net cash flow (15.00) 4.00
Monte Carlo Simulation
Step 1: Modeling the Project
Step 2: Specifying Probabilities
Step 3: Simulate the Cash Flows
Modeling Process
Monte Carlo Simulation
Flexibility & Real 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.
Real Options
1. Option to expand
2. Option to abandon
3. Timing option
4. Flexible production facilities
Decision Trees960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
+150(.6)
+30(.4)
+100(.6)
+50(.4)
-550
NPV= ?
-250
NPV= ?
-150
0
or
Turboprop
Piston
Decision Trees960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
+150(.6)
+30(.4)
+100(.6)
+50(.4)
-550
NPV= ?
-250
NPV= ?
-150
0
or
812
456
660
364
148
Turboprop
Piston
Decision Trees960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
+150(.6)
+30(.4)
+100(.6)
+50(.4)
-550
NPV= ?
-250
NPV= ?
-150
0
or
812
456
660
364
148 81220.22080.960
Turboprop
Piston
Decision Trees960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
-550
NPV= ?
-250
NPV= ?
-150
0
or
812
456
660
364
148
+150(.6)
+30(.4)
+100(.6)
+50(.4)
*450
331
45015010.1
660 450150
10.1
660Turboprop
Piston
Decision Trees960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
-550
NPV= ?
-250
NPV= ?
-150
0
or
812
456
660
364
148
+150(.6)
+30(.4)
+100(.6)
+50(.4)
NPV=444.55
NPV=888.18
NPV=550.00
NPV=184.55
*450
331
18.88815010.1
812 18.888150
10.1
812
Turboprop
Piston
Decision Trees960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
812
456
660
364
148
+150(.6)
710.73
+30(.4)
+100(.6)
403.82
+50(.4)
-150
0
*450
331
or
NPV=444.55
NPV=888.18
NPV=550.00
NPV=184.55
-550
NPV= ?
-250
NPV= ?
40.55.44460.18.888 40.55.44460.18.888
Turboprop
Piston
Decision Trees960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
812
456
660
364
148
+150(.6)
710.73
+30(.4)
+100(.6)
403.82
+50(.4)
-550
NPV=96.12
-250
NPV=117.00
-150
0
*450
331
or
NPV=444.55
NPV=888.18
NPV=550.00
NPV=184.55
12.9655010.1
73.710 12.96550
10.1
73.710
Turboprop
Piston
Decision Trees960 (.8)
220(.2)
930(.4)
140(.6)
800(.8)
100(.2)
410(.8)
180(.2)
220(.4)
100(.6)
812
456
660
364
148
+150(.6)
710.73
+30(.4)
+100(.6)
403.82
+50(.4)
-550
NPV=96.12
-250
NPV=117.00
-150
0
*450
331
or
NPV=444.55
NPV=888.18
NPV=550.00
NPV=184.55
Turboprop
Piston
Decision Trees
NPV of piston-engine plane when option to expand is ignored:
2)10.1(
)]100(6.)220(4[.4.]180(2.)410(8[.6.
10.1
)50(4.)100(6.250
Decision Trees
=+52, or €52,000
The value of the option to expand is, therefore:
117-52=+65, or €65,000
Decision Trees
NPV of piston-engine plane when option to expand is ignored:
=+52, or €52,000The value of the option to expand is, therefore:
117-52=+65, or €65,000
2)10.1(
)]100(6.)220(4[.4.]180(2.)410(8[.6.
10.1
)50(4.)100(6.250
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