Marko Hartmann, 2010-10-15
Most companies prepare each year a list of investment projects planned for the next coming year: The annual capital budget. However, being in the list of investments proposals not mean automatic go ahead with this project. Managers have to ask themselves what makes a project tick, what are the main uncertainties and how can you recognize these at an early stage. Therefore, we learn to use different kinds of analysis –methods like sensitive analysis, break-even analysis and Monte Carlo simulation. Options concerning which to expand when a project has a rising yield or which to abandon when things seem to be going wrong, called real options. We look at the real options, mostly constituting in desicion trees at the end of this documentation.
The Capital Investment Process
Investment proposals for the annual capital budget are mostly made “bottom-up”. They are sometimes inconsistent and have to be embedded in the company’s strategic planning which takes a ”top-down” view of the company. Therefore, you need to establish consensus forecasts of economic indicators to build a consistent basis for the capital budget.
After the capital budget has been admitted, the next step is to authorize each project. Therefore you need to submit an appropriation request which includes: - Detailed forecasts - Discounted cash-flow analysis (DCF) - Back-up information The final desicion is made by senior management, but it is the nature of the beast that forecasts are often biased and tend to be over optimistic while project risks are understated. Even if senior managers cannot wipe out bias completely they should learn to challenge the forecast critically.
Capter 11; Project Analysis
Appropriation requests approve the investment, the project has begun to run. But it is not advisable to lay back and let things take its course, you have to keep a check on the progress if you do not want to be caught by surprise. Post audits help managers to identify uncertainties and improve the processes when it comes to the next round of investments.
To reduce the risks of future uncertainties (Murphy´s law: “if anything can go wrong, it will”.) you have to ask yourself, what could happen in the future? You have to analyze the projects sensitivity. To do this, first figure out the underlying variables like - Market size - Share of market - Variable costs - Fixed costs Example 1: A Japanese company wants to launch an electrically powered motor scooter and prepared this cashflow forecast based on: Market size = 1,000,000 scooters Market share = 10% Unit sales/year = 100,000 scooters Price/unit = ¥375,000 Revenue = 100,000 x 375,000 = ¥37.5 bill. Variable costs/unit = ¥300,000 Total variable costs = 100,000 x 300,000 = ¥30 bill. Table 11.1 Investment Revenue Variable cost Fixed cost Depreciation Pretax Profit Tax Net profit Operating cash flow Net cash flow NPV Year 0 Years 1-10 15 37,5 30 3 1,5 3 1,5 1,5 3 -15 3,43 3
Notes: Market size (million) 1,00 Market share % 0,10 Price per unit (yen) 375.000 Variable costs (yen) 300.000 Tax rate % 50
Capter 11; Project Analysis
Cost of capital %
NPV = -15 +
= +¥3.43 bill.
Than they give optimistic and pessimistic values in turn to each variable and regard the resulting NPV´s. If the resulting range of NPV is wide and decrease distinctly on the negative side, take care of this variable. Table 11.2 Range Variable Market size, million Market share Unit price ¥ Unit variable cost¥ Fixed cost, bns ¥ Pess. 0,9 0,04 350.000 360.000 4 Expected Opt. 1 0,10 1,1 0,16 NPV (billions of yen) Pess. 1,13 -10,39 -4,25 -15,00 0,36 Expected Opt. 3,43 3,43 3,43 3,43 3,43 5,74 17,26 4,97 11,11 6,51
375.000 380.000 300.000 275.000 3 2
As you can see, the project is sensitive to the variables Market share and Unit variable costs.
Value of Information
The result of...