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Project Analysis


Earlier chapters explained how companies calculate a project's NPV by forecasting the cash flows and discounting them at a rate that reflects project risk. The end result is the project's contribution to shareholder wealth. Understanding discounted-cash-flow analysis is important, but there is more to good capital budgeting practice than an ability to discount.

First, companies need to establish a set of capital budgeting procedures to ensure that decisions are made in an orderly manner. Most companies prepare an annual capital budget, which is a list of investment projects planned for the coming year. Inclusion of a project in the capital budget does not constitute final approval for the expenditure. Before the plant or division can go ahead with a proposal, it will usually need to submit an appropriation request that includes detailed forecasts, a discounted-cash-flow analysis, and back-up information.

Sponsors of capital investment projects are tempted to overstate future cash flows and understate risks. Therefore firms need to encourage honest and open discussion. They also need procedures to ensure that projects fit in with the company's strategic plans and are developed on a consistent basis. (These procedures should not include fudge factors added to project hurdle rates in an attempt to offset optimistic forecasts.) Later, after a project has begun to operate, the firm can follow up with a postaudit. Postaudits identify problems that need fixing and help the firm learn from its mistakes.

Good capital budgeting practice also tries to identify the major uncertainties in project proposals. An awareness of these uncertainties may suggest ways that the project can be reconfigured to reduce the dangers, or it may point out some additional research that will confirm whether the project is worthwhile.

There are several ways in which companies try to identify and evaluate the threats to a project's success. The first is sensitivity analysis. Here the manager considers in turn each forecast or assumption that drives cash flows and recalculates NPV at optimistic and pessimistic values of that variable. The project is "sensitive to" that variable if the resulting range of NPVs is wide, particularly on the pessimistic side.

Sensitivity analysis often moves on to break-even analysis, which identifies break-even values of key variables. Suppose the manager is concerned about a possible shortfall in sales. Then he or she can calculate the sales level at which the project just breaks even (NPV = 0) and consider the odds that sales will fall that far. Break-even analysis is also done in terms of accounting income, although we do not recommend this application.

Sensitivity analysis and break-even analysis are easy, and they identify the forecasts and assumptions that really count for the project's success or failure. The important variables do not change one at a time, however. For example, when raw material prices are higher than forecasted, it's a good bet that selling prices will be higher too. The logical response is scenario analysis, which examines the effects on NPV of changing several variables at a time.

Scenario analysis looks at a limited number of combinations of variables. If you want to go whole hog and look at all possible combinations, you will have to turn to Monte Carlo simulation. In that case, you must build a financial model of the project and specify the probability distribution of each variable that determines cash flow. Then you ask the computer to draw random values for each variable and work out the resulting cash flows. In fact you ask the computer to do this thousands of times, in order to generate complete distributions of future cash flows. With these distributions in hand, you can get a better handle on expected cash flows and project risks. You can also experiment to see how the distributions would be affected by altering project scope or the ranges for any of the variables.

Elementary treatises on capital budgeting sometimes create the impression that, once the manager has made an investment decision, there is nothing to do but sit back and watch the cash flows unfold. In practice, companies are constantly modifying their operations. If cash flows are better than anticipated, the project may be expanded; if they are worse, it may be contracted or abandoned altogether. Options to modify projects are known as real options. In this chapter we introduced the main categories of real options: expansion options, abandonment options, timing options, and options providing flexibility in production.

Good managers take account of real options when they value a project. One convenient way to summarize real options and their cash-flow consequences is to create a decision tree. You identify the things that could happen to the project and the main counteractions that you might take. Then, working back from the future to the present, you can consider which action you should take in each case.

Decision trees can help to identify the possible impact of real options on project cash flows, but we largely skirted the issue of how to value real options.











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