Valuation analysis is used to evaluate the potential merits of an investment or to objectively assess the value of a business or asset. Valuation analysis is one of the core duties of a fundamental investor, as valuations (along with cash flows) are typically the most important drivers of asset prices over the long term.

1. Project Analysis
Session 5

2. Investment Process
STAGE 1: THE CAPITAL BUDGET
STAGE 2: PROJECT AUTHORIZATIONS
PROBLEMS AND SOME SOLUTIONS

Ensuring that Forecasts Are Consistent

Eliminating Conflicts of Interest

Reducing Forecast Bias

Sorting the Wheat from the Chaff

3. Some “What If” Questions


Managers want to understand more than the NPV of a project.
 If NPV is positive, they must seek to understand why such
an attractive project did not come from a competitor.
 And if the firm goes ahead with the project, and other copy a
such a profitable idea, will the firm still have some
competitive advantage?
They also want to predict what events could happen in an
uncertain environment they operate and how that might affect
NPV.
 Once they have done these predictions, management can
decide if it is worthwhile investing more time and effort in
understanding the uncertainty and trying to resolve it.

4. Some “What If” Questions
 Introduction

There are four methods managers use to
handle project uncertainty:
Sensitivity Analysis
 Scenario Analysis
 Simulation Analysis
 Break-Even Analysis


5. Some “What If” Questions

Sensitivity Analysis
 A sensitivity analysis calculates the consequences
of incorrectly estimating a variable in your NPV
analysis.
 If forces you:
 To identify the variables underlying your analysis.
 To focus on how changes to these variables
could impact the expected NPV.
 To consider what additional information should
be collected to resolve uncertainties about the
variables.

6. Some “What If”
Questions
Finefodder is
considering opening
a new superstore.
Cost of Capital 8%
NPV = 478,000
PV = $780,000 × 12-year annuity factor
= $780,000 × 7.536 = $5.878 million
NPV = PV – investment
= $5.878 million – $5.4 million = $478,000

7. Some “What If” Questions

8. Some “What If” Questions




Simulation Analysis
A scenario analysis is helpful to see how interrelated
variables impact NPV. But one must run several
hundred possible scenarios.
A simulation analysis uses a computer to generate
hundreds, or even thousands, of possible scenarios.
A probability distribution is assigned to each
combination of variables to create an entire range of
potential outcomes.

9. Sensitivity Analysis v/s Scenario Analysis

Sensitivity Analysis v/s Scenario Analysis

Both calculate how NPV depends on input assumptions

Sensitivity analysis changes inputs one at a time

Scenario analysis changes several variables at once

10. Break-Even Analysis

Accounting vs NPV Break-Even Analysis


A Break-Even analysis shows the level of sales at
which a company “breaks even”.
 An accounting break-even occurs where total
revenues equal total costs (profits equal zero).
 A NPV break-even occurs when the NPV of the
project equals zero.
Using accounting break-even can lead to poor
decisions.
 You can avoid this risk by using NPV break-even
in your analysis!

11. Break-Even Analysis

Accounting Break-Even
 You estimated sales to be $16 million.
 Variable costs were 81.25% of sales ($0.8125
of variable costs per $1 of sales).
 Fixed costs were $2 million and depreciation
was $450,000.
Break-Even Revenues
=
= $2,000,000 + $450,000
$1 - $0.8125
Fixed Costs + Depreciation
Profit per $1 of Sales
=
$2,450,000
$0.1875
=
$13,066,667

12. Break-Even Analysis

Accounting Break-Even

Creating an income statement at $13,066,667 of
sales shows profit equals zero:
Revenues
$13,066,667
Variable Costs (81.25% of sales)10,616,667
Fixed Costs + Depreciation
2,450,000
Pretax Profit
0
Taxes
0
Profit after Tax
0

13. Break-Even Analysis

Accounting Break-Even


If a project breaks even in accounting terms
is it an acceptable investment?
Clue: This project has a 12 year life …
Would you be happy with an investment
which after 12 years gave you a zero
total rate of return?

14. Break-Even Analysis

Accounting Break-Even

A project which simply breaks even on an accounting
basis will always have a negative NPV!
Proof:
Operating Cashflow
= profit after tax + depreciation
= $0 + $450,000 = $450,000
The initial investment is $5.4m. In each of the next 12 years, firm
receives a cashflow of $450,000. So firm gets its money back
Total operating cashflow= initial investment = 12*$450,000=$5.4m
But revenues are not sufficient to repay the opportunity
cost of that $5.4 million investment. NPV is negative.

15. Break-Even Analysis
Note: Cash flow = Depreciation + After Tax Profit

16. Break-Even Analysis

NPV Break-Even
This cash flow will last for 12 years. So to find its present value we multiply
by the 12-year annuity factor. With a discount rate of 8 percent, the present
value of $1 a year for each of 12 years is $7.536. Thus the present value of
the cash flows is
PV (cash flows) = 7.536 × (.1125 × sales – $1.02 million)
PV (cash flows) = investment
7.536 × (.1125 × sales – $1.02 million) = $5.4 million
–$7.69 million + .8478 × sales = $5.4 million
Sales = 5.4 + 7.69 / .8478
Sales = 15.4 million

17. Break-Even Analysis

NPV Break-Even


Using the accounting break-even, the
project had to generate sales of $13.067
million to have zero profit.
Using the NPV break-even, we find that the
project needs sales of $15.4 million to have
a zero NPV.

The project needs to be 18% more successful to break-even on
a NPV basis!

18. Flexibility in Capital Budgeting

The Value of Having Options


No matter how much analysis you do on a project, it is
impossible to completely eliminate uncertainty.
A firm must have the option:
To mitigate the effect of unpleasant surprises and
 to take advantage of pleasant ones?
Because the future is uncertain, successful financial managers
seek to build flexibility into a project.
The perfect project would have:
 The option to expand if things go well.
 The option to bail out or switch production if things go poorly.
 The option to postpone if future conditions might improve.




19. Flexibility in Capital Budgeting

The Value of Having Options



As a general rule, flexibility will be most valuable
to you when the future is most uncertain.
The ability to change course as events develop
and new information becomes available is most
valuable when it is hard to predict with
confidence what the best course of action will be.
Good outcomes can be exploited, while poor
outcomes can be avoided or postponed.

20. Flexibility in Capital Budgeting

Decision trees are used to diagram the
options in a project.
 You can then determine the optimal course
of action from a series of potential options.

A decision tree is defined as a diagram of
sequential decisions and their possible
outcomes.

21. Example of Decision Tree
Squares represent decisions to be made.
Circles represent
“A”
receipt of
information e.g. a
Study
test score.
“B”
finance
“C”
Do
not
study
“D”
“F”
The lines leading away
from the squares
represent the
alternatives.