Speaker 1: Hello everyone, welcome to today's lecture video. Today we will be running through a very condensed version of Chapter 11, which is about Project Analysis and Evaluation. So in this chapter, we really expand upon what we covered in Chapter 10 when we started to identify the cash flows associated with the project, and we take it one step further and really identify how do we evaluate or analyze these different projects and decide whether or not to actually move forward or reject a particular proposal. So our learning objectives in today's discussion are to perform and interpret first a scenario analysis for a proposed investment, secondly we will perform and interpret a sensitivity analysis for a proposed investment, and lastly we will explain how capital rationing affects the ability of a company to accept projects. So first of all, when we are evaluating net present value estimates, so that's from Chapter 9 where we introduced the different capital budgeting methods, net present value being the one most preferred and most aligned with our goal of maximizing shareholder wealth, we need to understand that net present value estimates are just that, they are estimates. So they are based on future cash flows of a project, which we calculated in Chapter 10, and these were based on our projections on what types of cash flows would occur with a particular project. Now what could happen if our cash flow estimates are too high? If your cash flow estimates are too high, it may lead you to accepting a project that shows a positive net present value, when in reality it should have actually had a negative net present value if our cash flow estimates were actually too high, the ones that we used in our capital budgeting analysis. Then on the other hand, what if your cash flow projections are too low? If your cash flow projections are too low, you may accidentally reject a project because it shows that it has a negative net present value, when in reality it should have a positive net present value. So you lose out on that opportunity to accept a project that would actually increase the value of the company. A positive net present value is a good start when you're evaluating a project, but since these decisions are long-term in nature, we also must take a closer look at our cash flow projections. Now this introduces a type of risk called forecasting risk. Forecasting risk is how sensitive is your net present value to changes in those cash flow estimates. The more sensitive your net present value is to small changes, we say that that project has greater forecasting risk. There's more of a risk that an incorrect decision will be made based on incorrect cash flow projections or estimations. Key thing is to look for sources of value. Why does this project actually create value? Whenever you are analyzing an investment, you should always be able to point to something about the investment that would lead to it having a positive net present value. So can you think of possible project characteristics that would lead to positive net present values? A couple things would be, can you actually really produce your product significantly better than your competition? Or can you really truly manufacture your product at a lower cost? Those are some different project characteristics that would indeed lead to positive net present value. The key point to remember is that with these positive net present value investments, they're probably not all that common, especially if you're looking at a competitive market. So you do need to incorporate some amount of economic sense and understand if the investment has properties that would actually lead to a positive net present value. So we turn our discussion to now, how can I deal with this forecasting risk? How can I deal with this possibility that my net present value calculation is somewhat incorrect due to incorrect cash flow projections or incorrect estimates for our future cash flows? First way is conducting what is called a scenario analysis. So in a scenario analysis, you ask what if questions. What if this were to happen or what if this were to happen? So what happens to the net present value under different cash flow scenarios? At a minimum, we should look at three main scenarios. First would be your best case. Well, I shouldn't say best case is your first, but your best case is all the good inputs go together. So highest revenues, lowest costs. You would then have worst case, which is your lowest revenues and your highest costs. And then what I should have said as your first projection would be your base case. So this is your most likely case, your original estimates. And based on these original estimates, then you have your best case scenario and also your worst case scenario. So your best case and worst case are not necessarily probable, but they can still be possible. So it is important to look at these projections to see what type of impact it has on net present value when you look at three different scenarios. So looking at an example here, we're just going to go through the different inputs that would go into this using a scenario analysis. So a project is under consideration, which will cost 1.2 million. It's a six year life project and no salvage value on this fixed asset investment. Depreciation is straight line to zero. We do realize from last chapter that depreciation does impact cash flows. Our required rate of return or otherwise referred to as your cost of capital is 21% and the tax rate is 34%. In addition, we have compiled the following information. What are the net present value and internal rate of returns for the base case, best case and worst case scenarios? So here we have our initial projections, your base case. Base case, we sell 20,000 units at $150 per unit. It's going to cost us $90 per unit to produce or manufacture this particular item and our fixed cost per year are 100,000. Now what we do is we assign upper bounds and lower bounds on these particular inputs. So worst case scenario, we would sell 15,000 units. Best case scenario, we would sell 25,000 units. Worst case scenario, our price per unit would be $125. Best case scenario, our price per unit is $175. Now pay close attention here. When we are talking about costs, in a best case scenario, it would be the highest sales, lowest cost. So if our variable cost per unit can actually be lower than our base case, this is our best case scenario, $80 per unit in variable cost. Worst case would be $100 per unit in variable cost. And then similarly, with fixed cost, the lowest cost would be our best case and the higher cost would be our worst case. So then what we could do is take what we learned in Chapter 10 and create pro forma income statements. So here we have our particular inputs. We create a pro forma income statement for each of the different scenarios. We take these different scenarios, these different projections and calculate operating cash flow as we discussed in the previous chapter. We did have four different methods, but you can also do EBIT plus depreciation minus taxes. That's the one that we have been most familiar with in this chapter or during this semester. And then based on that required rate of return that was 21%, we could take that initial cost of $1.2 million as CF0, take these operating cash flows as your cash flows for years one through six and calculate NPV and calculate IRR. Now if our base case NPV and IRR would showcase that you're going to accept the project, then obviously your best case scenario would also show that same acceptance. However, notice what happens in our worst case scenario here. Worst case scenario, our net present value is negative and your internal rate of return is less than your required rate of return. So in the event that the worst case scenario actually happened, we would actually end up accepting a project that has a negative net present value, decreasing the value of the company. So what this showcases is under this scenario, you would really want to look at these inputs for units, price per unit, variable cost per unit, and fixed costs and really try to identify what is the real possibility of this worst case scenario actually occurring. So some problems with scenario analysis that you're probably thinking about. First of all, it considers only a few possible outcomes, just that base case, best case, and worst case. And it assumes perfectly correlated inputs, meaning that all of the bad values go together. So highest cost, worst sales, and all the good values occur together. Highest sales, lowest cost, and we realize that that's not necessarily true. So what we can do is we can go even more detailed and conduct what is called a sensitivity analysis. With a sensitivity analysis, what happens to your net present value when we change one variable at a time? So how sensitive is your net present value to changes in one specific input? This is a subset of scenario analysis where we are looking at the effect of specific variables and their impact on net present value. Now the greater the volatility in your net present value in relation to a specific variable, the larger the forecasting risk associated with that variable, and the more attention you'll want to pay to its estimation. So you'll look at these different inputs and identify which of the variables, which of our inputs, create the most changes in our net present value projections. Those variables are said to have higher forecasting risk, where you really want to dive into those particular estimates and try to certify to the best of your ability that those estimates are indeed correct. So what we can do is we can chart this sensitivity analysis based on net present value and changes in that particular unit. Here what we have is net present value on our vertical axis, and the one unit we are changing is unit sales. Now as you can see, all of the other units remain the same. So we have our base case in units sold, price per unit, variable cost per unit, and fixed cost per unit. All of these units, all of these inputs stay the same. The only one that we change then is the number of units being sold, and we conduct a sensitivity analysis and look at what happens to your net present value when I only change that one particular input. Once again, we create a pro forma income statement, calculate operating cash flow, and then use our net present value calculations, and we see that yes, base case we do have a positive net present value, however, in the worst case scenario for units sold, it leads to a negative net present value. So what you would want to do is really look at this estimation for the number of units sold and see what is really the possibility of only 55 units being sold, and what you would do then is you would do this sensitivity analysis by changing the different inputs. So looking at another sensitivity analysis, but here we change fixed costs, so once again, all of our other inputs stay the same from your base case, so the number of units sold, the price per unit, the variable cost per unit, the only input that we are changing now is fixed cost, and we can see here after creating your pro forma income statements and calculating operating cash flow that underneath all three scenarios, we have a positive net present value. So what you would conclude and would be able to say is that that input of units sold from the previous page, from the previous slide, that input has more forecasting risk, so you will really need to look at that particular input and do some further market research to identify what are the possibilities of that lower bound input actually occurring. So that is a sensitivity analysis. Now when you conduct both a scenario analysis and a sensitivity analysis, you must be aware of paralysis of analysis, doing too many analyses and not ever coming to a conclusive decision as to whether or not to move forward with the project. So at some point, you do have to make a decision. If the majority of your scenarios have positive net present values, then you can feel reasonably comfortable about accepting the project, however, if you do have a crucial variable such as in the previous example, the number of units sold, that leads to a negative net present value with only small changes in that estimate, then you may want to forgo the project simply due to the fact that all of these projections are based on estimates and if your net present value is going to change pretty largely for very small changes in a particular input, the possibility that that particular input may be that lower value and impact your net present value is high, so you may just want to go and forgo that opportunity until you can find a better project. Now this leads us to our final part of this chapter, which discusses capital rationing. So with capital rationing, it is a situation that exists if a firm has positive net present value projects but cannot find the necessary financing. So this situation exists for these firms that do have positive net present value projects, but they do not have the funds to actually take on that project because you can't choose every single project that has a net present value that's positive, each of these firms has limited funds and with this type of capital rationing, you have two different types. Soft rationing is the limited resources are temporary, often self-imposed. So this is something where maybe a company is restricting or allocating a certain amount of financing for capital budgeting and not anything more than that, so maybe there's a project that would cost more and they could technically raise funds for that project if necessary, but their limitations are self-imposed and they would have to reject this project due to insufficient funding, even though they could actually obtain more funds out in the capital markets if the management actually wanted to do so. Now on the other hand, you have hard rationing and this is a situation that occurs when a business cannot raise financing for a project under any circumstances. So the capital will never be available for this project, you must reject everything. If a company is in the situation of hard rationing, that would be pretty detrimental to company goals of maximizing shareholder wealth. So capital rationing is just discussing that you're rationing the amount of funds available and there's two different types, soft rationing and hard rationing. Now if you think back to Chapter 9 when we discussed the different capital budgeting methods, the last one that we discussed was the profitability index, which was a measure of how much bang for your buck are you getting. So how much present value cash inflows are you getting per dollar, present value cash outflows or costs, and this method is a useful capital budgeting method when a manager is faced with soft rationing. So pick those projects, if you have limited funds, picking those projects that give you the most bang for your buck. So as I mentioned, that is a condensed version of Chapter 11, just some different things that companies can do to better evaluate these different capital budgeting projects. And so that concludes this chapter. If you do have any questions or comments about anything, please do not hesitate to reach out. Thanks and have a great rest of your day.