F305Intermediate Corporate Finance

Indiana University

Class 5

Project Analysis – Managerial Options

While planning is essential, things rarely work out as planned! So, what if:

We miss sales projections Timing is not what was expected A project is wildly successful Effect on other products is unexpected The economy has changed The discount rate changes Cost estimates are incorrect

The Case of Daimler-Chrysler

What Are Management’s Options?

The company can postpone (Timing Option)

Scale back or abandon Build in flexibility Expand or duplicate Strategic options

Test marketSmall scale tests

The Timing Option Most attractive when:

Uncertainty is large Immediate project cash flows are small

The Abandonment Option Treated as an Option in investments

Provides partial insurance against failure Similar to a Put option, with the exercise price equal

to the value of the project’s assets if they were sold or shifted to a more valuable use

So, provides a means to assign an abandonment value to the cash flow and arrive at a value including abandonment

Built-in Flexibility

Is a project convertible to alternative uses? Inputs Outputs Expansion

Each alternative is assigned a probability to arrive at an overall NPV for the flexible project

Option to expand a project not built in to the original plan

What if?

Scenario Analysis – allows the analyst to change multiple variables at once. If many conditions change, what is the effect on the project analysis

Sensitivity Analysis – how sensitive is the analysis to single factor fluctuation?

Break Even Analysis The trade off between fixed costs and variable costs Accounting break-even

Break Even Analysis Consider the following two cost structures

FC(A) + VC(A) * Q where FC = 40,000 and variable costs are $0.30

FC(B) + VC(B) * Q where FC = 60,000 and variable costs are $0.15

At what point are we indifferent to the cost structure? If Cost structure A had Q = 20,000, how many

additional units would have to be sold under cost structure B to make the two cost structures comparable?

Break Even Analysis

Consider the following variables P = price per unit v = variable cost per unit Q = number of units sold FC = fixed costs D = depreciation T = tax rate

Then

B/E Q = (FC + D) / (P – v) Q = (40,000+4,000) / ($3.00 - $.30)