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Chapter 11
PROJECT ANALYSIS AND EVALUATION
CHAPTER ORGANIZATION
11.1 Evaluating NPV Estimates
11.2 Scenario and Other What-If Analyses
11.3 Break-Even Analysis
11.4 Operating Cash Flow, Sales Volume, and Break-Even
11.5 Operating Leverage
11.6 Capital Rationing
11.7 Summary and Conclusions
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ANNOTATED CHAPTER OUTLINE
11.1. Evaluating NPV Estimates
A. The Basic Problem
B. Projected versus Actual Cash Flows
C. Forecasting Risk
D. Sources of Value
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Lecture Tip: Perhaps the single largest source of positive NPVs is
Real-World Tip: In “Corporate Strategy and the Capital
Budgeting Decision” (Midland Corporate Finance Journal,
11.2. Scenario and Other What-If Analyses
A. Getting Started
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B. Scenario Analysis
Worst-case/Best-case scenarios: putting lower and upper bounds
Lecture Tip: A major misconception about a project’s estimated
Lecture Tip: You may wish to integrate this discussion of risk with
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You might also want to point out that the cases examined in this
C. Sensitivity Analysis
To conduct a sensitivity analysis, hold all projections constant
Lecture Tip: If desired, it may be a good point at which to
demonstrate the Solver function in Excel, as you can identify how
high/low an input could go before NPV becomes negative.
D. Simulation Analysis
Computers are used to estimate thousands of possible scenarios.
Lecture Tip: A very useful software is Crystal Ball, which is a
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11.3. Break-Even Analysis
Break-even analysis is a widely used technique for analyzing sales
volume and profitability. More to the point, it determines the sales
volume necessary to cover costs and implicitly asks, “Are things
likely to go that well?”
Ethics Note: The following case might be used to discuss the
Now ask the students to determine the break-even quantity for the
new procedure:
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A. Fixed and Variable Costs
Variable costs (VC) are the costs that change as the volume of
Lecture Tip: You may wish to emphasize that, in computing total
Lecture Tip: Students should recognize that as quantity increases,
total fixed costs remain constant, but, on a per unit basis, they
Chapter 11 – Project Analysis and Evaluation
B. Accounting Break-Even
C. Accounting Break-Even: A Closer Look
What sales level gives $0 net income (assuming things are the
same each year)? This happens when sales equal total costs.
D. Uses for the Accounting Break-Even
Knowledge of the accounting break-even point allows us to better
evaluate the level of forecast risk inherent in our cash flow
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11.4. Operating Cash Flow, Sales, Volume, and Break-Even
A. Accounting Break-Even and Cash Flow
Ignore taxes for simplification:
1. Calculate the quantity (Q) necessary for accounting break-even.
Using the following information:
B. Sales Volume and Operating Cash Flow
Again, ignore taxes for simplification:
C. Cash Flow, Accounting and Financial Break-Even Points
Use the following information. The price is $3 per unit and the
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Lecture Tip: Inquisitive students may ask how the computations
change when you include taxes. The equations change as follows:
11.5. Operating Leverage
There is almost always some flexibility in production to decide between
fixed and variable costs. Fixed costs generally magnify forecasting errors,
as well as reduce the firm’s flexibility in the production process.
A. The Basic Idea
B. Implications of Operating Leverage
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C. Measuring Operating Leverage
Example:
D. Operating Leverage and Break-Even
11.6. Capital Rationing
A. Soft Rationing – management decides to limit capital that will be
raised
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Lecture Tip: In 2008, the economy was suffering from a real estate
11.7. Summary and Conclusions