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