Topic 10: Project Analysis and Evaluation (Sem 2) Flashcards
Risk
Chance or possibility of loss or bad consequences
Evaluating NPV Estimates segments
The Basic Problem:
Project appraisals are based on projections or estimates of future cash flows. Estimates about the future might be wrong.
Projected VS Actual cash flows
Projected is not actual
Projected is approximately ‘average’ of possible outcomes.
Scenario Analysis
What happens to NPV estimates when we ask ‘what-if’ questions
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Sensitivity Analysis
Investigation of what happens to NPV when only one variable is changed
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Simulation Analysis
A combination of scenario and sensitivity analysis.
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Project Evaluation and Case study
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Break even analysis
Refers to the point at which total costs and total revenues are equal or ‘even’
This tells you the sales volume you need to start making money. It summarises the relationship between sales volume and profitability.
Three types of break even
1) Accounting - Sales level that results in zero project net income
2) Cash - Sales level that results in a zero operating cash flow
3) Financial - Sales level that results in a zerp NPV.
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Fixed Costs (FC)
Costs that do not change when the quantity of output change during a particular time period
Variable Costs (VC)
Costs that change when the quantity of output changes
Total Variable Cost Formula
Total variable cost = Total quantity of output (Q) * Cost per unit of output (V)
I.e: VC = Q * V
Where: VC = Total variable cost
Total costs
The sum of the variable costs (VC) and the fixed costs (FC)
TC = VC + FC
or
TC = Q*V + FC
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Marginal (or incremental) costs
Change in costs that occur when there is a small change in output (Q)
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Accounting break even formula
Q = (FC + D) / (P - V)
Where:
Q = Total units sold
FC = Fixed costs
D = Depreciation
P = Selling price per unit
V = Variable cost per unit
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Net Income Formula
NI = (S - VC - FC - D) * (1 - T)
Where:
NI = Net income
S = Total sales (Price * Quantity sold)
VC = Total variable costs (Variable cost per unit * Total units sold)
FC = Fixed costs
D = Depreciation
T = Tax rate
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Relationship between operating cashflow and sales volume (ignoring taxes)
OCF = (P - V) * Q - FC
Notes: if this is rearranged and solved for Q we get the sales volume (Q) necessary to achieve any given operating cash flow.
Cash break even formula
Q = (FC + OCF) / (P - V)
Where:
Q = Total units sold (necessary sales volume)
FC = fixed costs
OCF = Operating cash flow
P = Selling price per unit
V = Variable cost per unit
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Financial break even formula
Same formula as cash break even can be used:
Q = (FC + OCF) / (P - V)
Where:
Q = Total units sold (necessary sales volume)
FC = fixed costs
OCF = Operating cash flow
P = Selling price per unit
V = Variable cost per unit
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Operating Leverage
The degree to which a firm or project relies on fixed costs
High Operating leverage = high fixed costs for the company. Furthermore is means that a small percentage change in operating revenue can be magnified inro a large percentagre change in operating cash flow and net present value. Also means greater levels of forecasting risks
Low Operating leverage = low fixed costs for the company.
Note: Projects with heavy investments in plant and equipment will have high operating leverage and are said to be capital intensive.
degree of operating leverage (DOL)
The percentage change in operating cash flow relative to the percentage change in quantity sold.
Percentage change in OCF (Formula)
Percentage chance in OCF = DOL X percentage change in Q
Note: Based on th relationship between OCF and Q, DOL can be written as:
DOL = 1 + FC / OCF
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Capital Rationing
The situation that exists if a firm has positive NPV projects but cannot find the necessary financing.
Soft Rationing
The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting.
Hard Rationing
The situation that occurs when a business cannot raise financing for a project under any circumstances.
