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Project Analysis and Evaluation
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Key Concepts and Skills
Understand forecasting risk and sources
of value
Understand and be able to do scenario
and sensitivity analysis
Understand the various forms of break-
even analysis
Understand operating leverage
Understand capital rationing
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Chapter Outline
Evaluating NPV Estimates
Scenario and Other What-If Analyses
Break-Even Analysis
Operating Cash Flow, Sales Volume, and
Break-Even
Operating Leverage
Capital Rationing
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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
Sources of value why does this project create
value?
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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
Best case and worst case are not necessarily
probable, but they can still be possible
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New Project Example
Consider the project discussed in the text
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%
The base case NPV is 15,567
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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 vary 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 6000 59,800 15,567 15.1%
Worst case 5500 53,200 -8,226 10.3%
Best case 6500 66,400 39,357 19.7%
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Simulation Analysis
Simulation is really just an expanded sensitivity and
scenario analysis
Monte Carlo simulation can estimate thousands of
possible outcomes based on conditional probability
distributions and constraints for each of the variables
The output is a probability distribution for NPV with an
estimate of the probability of obtaining a positive net
present value
The simulation only works as well as the information that
is entered and very bad decisions can be made if care is
not taken to analyze the interaction between variables
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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 net income =
0
Cash break-even sales volume at which operating cash flow
= 0
Financial break-even sales volume at which net present
value = 0
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Example: Costs
There are two types of costs that are important in
breakeven analysis: variable and fixed
Total variable costs = quantity * cost per unit
Fixed costs are constant, regardless of output, over some time
period
Total costs = fixed + variable = FC + vQ
Example:
Your firm pays $3000 per month in fixed costs. You also pay
$15 per unit to produce your product.
What is your total cost if you produce 1000 units?
What if you produce 5000 units?
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Average vs. Marginal Cost
Average Cost
TC / # of units
Will decrease as # of units increases
Marginal Cost
The cost to produce one more unit
Same as variable cost per unit
Example: What is the average cost and marginal cost under
each situation in the previous example
Produce 1000 units: Average = 18,000 / 1000 = $18
Produce 5000 units: Average = 78,000 / 5000 = $15.60
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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
< 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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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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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?
Similar process to that of finding the bid price
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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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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Capital Rationing
Capital rationing occurs when a firm or
division has limited resources
Soft rationing the limited resources are
temporary, often self-imposed
Hard rationing capital will never be
available for this project
The profitability index is a useful tool
when a manager is faced with soft
rationing

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Quick Quiz
What is sensitivity analysis, scenario analysis
and simulation?
Why are these analyses important and how
should they be used?
What are the three types of break-even and
how should each be used?
What is degree of operating leverage?
What is the difference between hard rationing
and soft rationing?
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End of Chapter
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Comprehensive Problem
A project requires an initial investment of $1,000,000,
and is depreciated straight-line to zero salvage over its
10-year life. The project produces items that sell for
$1,000 each, with variable costs of $700 per unit. Fixed
costs are $350,000 per year.
What is the accounting break-even quantity, operating
cash flow at accounting break-even, and DOL at that
output level?