Topic 10: Project Analysis and Evaluation (Sem 2)

Question 1

Risk

Answer 1

Chance or possibility of loss or bad consequences

Question 2

Evaluating NPV Estimates segments

Answer 2

The Basic Problem:
Project appraisals are based on projections or estimates of future cash flows. Estimates about the future might be wrong.

Question 3

Projected VS Actual cash flows

Answer 3

Projected is not actual
Projected is approximately ‘average’ of possible outcomes.

Question 4

Scenario Analysis

Answer 4

What happens to NPV estimates when we ask ‘what-if’ questions

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Question 5

Sensitivity Analysis

Answer 5

Investigation of what happens to NPV when only one variable is changed

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Question 6

Simulation Analysis

Answer 6

A combination of scenario and sensitivity analysis.

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Question 7

Project Evaluation and Case study

Answer 7

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Question 8

Break even analysis

Answer 8

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.

Question 9

Three types of break even

Answer 9

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.

CHECK EXAMPLE OF EACH IN NOTES

Question 10

Fixed Costs (FC)

Answer 10

Costs that do not change when the quantity of output change during a particular time period

Question 11

Variable Costs (VC)

Answer 11

Costs that change when the quantity of output changes

Question 12

Total Variable Cost Formula

Answer 12

Total variable cost = Total quantity of output (Q) * Cost per unit of output (V)

I.e: VC = Q * V
Where: VC = Total variable cost

Question 13

Total costs

Answer 13

The sum of the variable costs (VC) and the fixed costs (FC)

TC = VC + FC
or
TC = Q*V + FC

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Question 14

Marginal (or incremental) costs

Answer 14

Change in costs that occur when there is a small change in output (Q)

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Question 15

Accounting break even formula

Answer 15

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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Question 16

Net Income Formula

Answer 16

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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Question 17

Relationship between operating cashflow and sales volume (ignoring taxes)

Answer 17

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.

Question 18

Cash break even formula

Answer 18

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

CHECK EXAMPLE IN NOTES

Question 19

Financial break even formula

Answer 19

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

CHECK EXAMPLE IN NOTES

Question 20

Operating Leverage

Answer 20

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.

Question 21

degree of operating leverage (DOL)

Answer 21

The percentage change in operating cash flow relative to the percentage change in quantity sold.

Question 22

Percentage change in OCF (Formula)

Answer 22

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

CHECK EXAMPLE IN NOTES

Question 23

Capital Rationing

Answer 23

The situation that exists if a firm has positive NPV projects but cannot find the necessary financing.

Question 24

Soft Rationing

Answer 24

The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting.

Question 25

Hard Rationing

Answer 25

The situation that occurs when a business cannot raise financing for a project under any circumstances.