HANDLING PROJECT UNCERTAINTY

Chapter 10

Handling Project Uncertainty Uncertaint

Origin of Project Risk Methods of Describing Project Risk

Origins of Project Risk

Risk is to describe investment project where cash flows are NOT KNOWN in advance with certainty certainty. Project risk refer to variability in a projects PW. We can see risk as the potential for loss. Risk Analysis is the Ri k A l i i th assignment of probabilities t th various i t f b biliti to the i outcomes of an investment project.

When deciding whether or not to make a major capital investment investment, such as introducing a new product, a number of issues must be considered and estimated. The factors to be estimated include the total market for the product; the market share that the firm can achieve; the growth in the market; the cost of producing the product; the selling price; the life f th lif of a product; d t the cost and the life of equipment needed; the effective tax rates. Many of these factors are subject to uncertainty.

Methods of Describing Project Risk

First, begin analyzing project risk by determining the uncertainty inherent in a project cash flows. We can do this analysis in a number of ways such as the following; 1. Sensitivity Analysis (SA) is technique of i i at h i f investment analysis whereby diff t t l i h b different values of certain t l f t i key variables are tested to see how sensitive investment results are to possible change in assumptions. SA sometimes called What if analysis because it answers questions such as, If incremental sales are only 1,000 units, rather than 2,000 units? What will be the NPW be?

Sensitivity Analysis begins with a base-case situation, which is developed using most likely values for each input most-likely input. We then change the specific variable of interest by several specified percentages above and below the most likely value, while holding other variables constant. Next, Next we calculate a new NPW for each of these values values. A useful way to present results of sensitivity analysis is to plot sensitivity graphs.

Case # 1 Example of Sensitivity Analysis

BMC, a small manufacturer of fabricated metal parts, must decide whether to enter competition to become the supplier of transmission housings for GEC that produces the housings in its own in-house manufacturing facility, but that has almost reached its maximum production capacity. Therefore, GEC is looking for an outside supplier. To compete, BMC must design a new fixture for the production process and purchase a new furnace. The available details for this purchase are p p as follows: The new furnace would cost $125 000 $125,000.

If BMC gets the order, it may be able to sell as many as 2,000 units per year to GEC for $50 each. In the case of variable cost, such as direct labor and direct material cost, will be $15 per unit. Fixed cost will amount to $10,000 per year. The firm expects that the proposed transmission housing project will be about five year. The firm also estimates that the amount ordered by GEC y y in the first year will be ordered in each of the following four years. The initial investment can be depreciated on a MACRS basis over a 7 year 7-year period, and the marginal income tax rate is expected to remain at 40%. At the end of f years, the f h d f five h furnace is expected to retain or k d keep a market k value of about 32% of the original investment.

What Makes BMC Managers Worry:

BMC s BMCs managers are uncomfortable about this project because project, too many uncertain elements have not been considered in the analysis. l i If BMC decided to take the project BMC would have to invest in project, the furnace to provide GEC with some samples as a part of the bidding process process. If GEC do not like BMCs sample, BMC would continue to lose its BMC s entire investment in the furnace.

If GEC like BMCs sample, then if it was overpriced, BMC would be under pressure to bring the price in line with competing firms. Even the possibility that BMC would get a smaller order must be considered, as GEC may utilize its overtime capacity to produce , y p y p some extra units. Finally, BMC is not certain about its projections of variable and fixed costs costs. Recognizing these uncertainties, the managers want to assess the various possible f bl future outcomes b f before making a f l d k final decision. Put yourself in BMCs management position, and describe how you may solve the uncertainty associated with the project.

Case # 1 Example Sensitivity Analysis summary

Transmission-Housing Project by BMC New investment = $125,000 $125 000 Number of units = 2,000 units Unit Price = $50 per unit Unit variable cost = $15 per unit Fixed cost = $10,000/Yr Project Lif P j t Life = 5 years Salvage value = $40,000 Income tax rate = 40% MARR = 15% Determine the acceptability of the investment p y

Depreciation Calculation
The firm expects that the proposed project will have five year project life. Cost Base = $125,000 and Recovery Period = 7-year MACRS

N
1 2 3 4 5 6 7 8

MACRS 7 - year Rates

14.29 % 24.49 % 17.49 % 12.49 % 8.93 8 93 % 8.92 % 8.93 % 4.46 %

Depreciation Amount
$17,863 $30,613 $21,863 $15,613 $11,162.5 $11 162 5 $11,150 $11,150 $5,575

Allowed Depreciation Amount

$17,863 $30,613 $21,863 $15,613 $ 5,581 5 581 TOTAL $ 91,533 0 0 0

12

Cash Flow for BMCs Transmission Housings Project Base Case Income Statement
Revenues: Unit Price Demand (units) Sales revenue Expenses: Unit variable cost Variable cost Fixed cost Depreciation Taxable Income Income taxes (40%) Net I N Income $15 30,000 , 10,000 17,863 $42,137 16,855 $25,282 $25 282 $15 30,000 , 10,000 30,613 $29,387 11,755 $17,632 $17 632 $15 30,000 , 10,000 21,863 $38,137 15,255 $22,882 $22 882 $15 30,000 , 10,000 15,613 $44,387 17,755 $26,632 $26 632 $15 30,000 , 10,000 5,581 $54,419 21,768 $32,651 $32 651 50 2,000 $100,000 50 2,000 $100,000 50 2,000 $100,000 50 2,000 $100,000 50 2,000 $100,000

Gains (Losses) associated with Asset Disposal

Salvage value = $40,000 Book Value (year 5) = Cost Base Total Depreciation = $125 000 - $ 91,533 $125,000 91 533 = $ 33,467 Taxable gains = Salvage Value Book Value = $40,000 - $ 33,467 = $6,533 Gains taxes = (Taxable Gains) (Tax Rate) = $6,533 x (0.40) = $2,613 ,
14

(E Example Continued) l C ti d
Cash Flow Statement
Operating activities Net income Depreciation 25,282 17,863 17,632 30,613 22,882 21,863 26,632 15,613 32,651 5,581 0 1 2 3 4 5

Investment activities
Investment Salvage Gains tax (125,000) 40,000 ( , (2,613) ) ($125,500) $43,145 $48,245 $44,745 $42,245 $75,619

Net cash flow

Table: BMC's Transmission-Housings Project

Income Statement I St t t 0 Revenues: Unit Price Demand (units) Sales Revenue Expenses: Unit Variable Cost Variable Cost Fixed Cost Depreciation Taxable I T bl Income Income Taxes (40%) Net Income Cash Flow Statement Operating Activities: Net Income Depreciation Investment Activities: Investment (125,000) Salvage Gains Tax G i T Net Cash Flow $ (125,000) $ $ 1 2 3 4 5

50 $ 50 $ 50 $ 50 $ 50 2000 2000 2000 2000 2000 $ 100,000 $ 100,000 $ 100,000 $ 100,000 $ 100,000 $ 15 30,000 10,000 17,863 42,137 42 137 16,855 25,282 $ 15 30,000 10,000 30,613 $ 15 30,000 10,000 21,863 38,137 38 137 15,255 22,882 $ 15 30,000 10,000 15,613 $ 15 30,000 10,000 5,581 54,419 54 419 21,768 32,651

$ $

$ 29 387 29,387 11,755 $ 17,632

$ $

$ 44 387 44,387 17,755 $ 26,632

$ $

25,282 17,863 17 863

17,632 30,613 30 613

22,882 21,863 21 863

26,632 15,613 15 613

32,651 5,581 5 581

40,000 (2,613) (2 613) 43,145 $ 48,245 $ 44,745 $ 42,245 $ 75,619

Is this investment justifiable at a MARR of 15%? PW(15%) = -$125,000 + +$43,145(P/F, 15%, 1) + . . . . +$75,619(P/F, 15%, 5) = $40,169 > 0 Accept the Project
$125,000
$43,145 $48,245 $44,745 $42,245 $75,619

0
1 2 3 4 5

Years

17

INPUT VALUE OF UNIT PRICE 20% LESS AND OTHERS ARE SAME
Table BMC's Transmission-Housings Project
Income Statement 0 Revenues: Unit Price Demand (units) Sales Revenue Expenses: Unit Variable Cost Variable Cost Fixed Cost Depreciation D i ti Taxable Income Income Taxes (40%) Net Income Cash Flow Statement Operating Activities: Net Income Depreciation Investment Activities: Investment (125,000) Salvage Gains Tax Net Cash Flow $ 1 2 3 4 5

40 $ 40 $ 40 $ 40 $ 40 2000 2000 2000 2000 2000 $ 80,000 $ 80,000 $ 80,000 $ 80,000 $ 80,000 , , , , , $ 15 $ 15 $ 15 $ 15 $ 15 30,000 30,000 30,000 30,000 30,000 10,000 10,000 10,000 10,000 10,000 17,863 17 863 30,613 30 613 21,863 21 863 15,613 15 613 5,581 5 581 9,387 $ 18,137 $ 24,387 $ 34,419 3,755 7,255 9,755 13,768 5,632 $ 10,882 $ 14,632 $ 20,651

$ 22,137 $ 8,855 $ 13,282 $

13,282 17,863 17 863

5,632 30,613 30 613

10,882 21,863 21 863

14,632 15,613 15 613

20,651 5,581 5 581

40,000 (2,613)

$ (125,000) $ 31,145 $ 36,245 $ 32,745 $ 30,245 $ 63,619

Is this investment justifiable at a MARR of 15%? PW(15%) = -$125,000 +$31,145(P/F, 15%, 1) +$36,245(P/F, 15%, 5) +$32,745(P/F, 15%, 5) $32,745(P/F, +$30,245(P/F, 15%, 5) +$63,619(P/F, 15%, 5) = - $57 No, Do not accept the Project
0
1 2 3 4 5

$63,619 $36,245 $31,145

$32,745 $30,245

Years $125,000

19

Table Sensitivity A l i f Fi K I T bl - S iti it Analysis for Five Key Input Variables t V i bl

Deviation Unit price Demand Variable cost Fixed cost Salvage value

-20%
$(57) 12,010 52,236 44,191 37,782

-15%

-10%

-5%

0%

5%

10%

15%

20%

$9,999 $20,055 $30,111 $40,169 $50,225 $60,281 $70,337 $80,393 $9 999 $20 055 $30 111 $40 169 $50 225 $60 281 $70 337 $80 393 19,049 49,219 43,185 38,378 26,088 46,202 42,179 38,974 33,130 43,186 41,175 39,573 40,169 40,169 40,169 40,169 47,208 37,152 39,163 40,765 54,247 34,135 38,157 41,361 61,286 31,118 37,151 41,957 68,325 28,101 36,145 42,553

Base

EXERCISE INPUT VALUE OF DEMAND 20% LESS AND OTHERS ARE SAME
Table BMC's Transmission-Housings Project
Income Statement

0
Revenues: Unit Price Demand (units) Sales R S l Revenue Expenses: Unit Variable Cost Variable Cost Fixed Cost Depreciation Taxable Income Income Taxes (40%) Net Income Cash Flow Statement Operating Activities: Net Income Depreciation Investment Activities: Investment (125,000) Salvage Gains Tax Net Cash Flow $ (125,000) $ $ $ $

5
50 1600 80,000 80 000 15 24,000 10,000 5,581 40,419 16,168 24,251 24 251

50 $ 50 $ 1600 1600 80,000 80 000 $ 80 000 $ 80,000 15 24,000 10,000 17,863 28,137 11,255 16,882 16 882 $ 15 24,000 10,000 30,613 $

50 $ 50 $ 1600 1600 80,000 80 000 $ 80 000 $ 80,000 15 24,000 10,000 21,863 24,137 9,655 14,482 14 482 $ 15 24,000 10,000 15,613 $

$ $

$ 15,387 6,155 $ 9,232 9 232

$ $

$ 30,387 12,155 $ 18 232 18,232

$ $

16,882 17,863

9,232 30,613

14,482 21,863

18,232 15,613

24,251 5,581

40,000 (2,613) (2 613) 34,745 $ 39,845 $ 36,345 $ 33,845 $ 67,219

Is this investment justifiable at a MARR of 15%? f PW(15%) = -$125,000 +$34,745(P/F, 15%, 1) +$39,845(P/F, 15%, 5) +$36,345(P/F, 15%, +$36 345(P/F 15% 5) +$33,845(P/F, 15%, 5) +$67,219(P/F, 15%, 5) = $12,010 > 0
0
1 2 3 4 5

$67,219 $39,845 $34,745

$36,345 $33,845

accept the Project

$125,000

Years

22

Table - Sensitivity Analysis for Five Key Input Variables

Deviation Unit price Demand Variable cost Fixed cost Salvage value

-20%
$(57) 12,010 52,236 44,191 37,782

-15%

-10%

-5%

0%

5%

10%

15%

20%

$9,999 $20,055 $30,111 $40,169 $50,225 $60,281 $70,337 $80,393 $9 999 $20 055 $30 111 $40 169 $50 225 $60 281 $70 337 $80 393 19,049 49,219 43,185 38,378 26,088 46,202 42,179 38,974 33,130 43,186 41,175 39,573 40,169 40,169 40,169 40,169 47,208 37,152 39,163 40,765 54,247 34,135 38,157 41,361 61,286 31,118 37,151 41,957 68,325 28,101 36,145 42,553

Base

$100,000 90,000 90 000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 20 000 10,000 0 -10,000

In this graph we can see that the projects NPW is (1) very sensitive to changes in product demand and unit price, (2) fairly sensitive to changes in variable cost, and (3) relatively insensitive to changes in the fixed cost and salvage value. Unit Price Demand

Salvage value Base Fixed cost Variable cost

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Sensitivity graph BMCs transmission - housings project

CASE # 2

Example 10.1 Sensitivity Analysis

CTCorp is the worlds leading provider of micro-turbine based MicroCHP (combined heat and power) systems for clean, continuous, distributed-generation electricity. The MicroCHP unit is a compact turbine generator that delivers electricity on-site, or close to the point where it is needed Designed to operate on a variety of gaseous needed. and liquid fuels, this form of distributed-generation technology first introduced in 1998 for commercial use.

... Example 10.1 ...

Capstone is considering marketing a modified, but downsized, version of the system unit for residential use, primarily for vacation properties in remote places The project requires an initial investment of $55 million places. million, but Capstone managers are nervous about this project, because too many uncertain elements have not been considered in the analysis. Two primary factors that are difficult to estimate are the initial market size and how the market size will grow over the life of the project. The g p j company has prepared the following financial data related to the project:

The initial investment can be depreciated on a seven-year MACRS and the MACRS, project is expected to have an economic service life of five years. The product life is relatively short, as the technology changes in the energy sector are changing rapidly The firms marginal tax rate is 40% and its MARR is known rapidly. 40%, to be 15%. (a) Develop the cash flow series over the project life, based on the assumption of most-likely estimates. (b) Conduct a sensitivity analysis for each variable and develop a sensitivity graph. graph

... Example 10 1 ... 10.1

Capstone Turbine Corporation New investment = $ million $55 ll Initial market size (units), year one = 1,500 units Unit Price = $80,000 per unit $ , p Unit variable cost = $60,000 per unit Fixed cost = $8,000,000/Yr Project Life P j t Lif = 5 years Salvage value = $7,000,000 Income tax rate = 40% MARR = 15% Develop the cash flow series over the project life based on the assumption of most-likely estimates most likely estimates. Conduct a sensitivity analysis for each variable and develop a sensitivity graph.

Depreciation Calculation
The firm expects that the proposed project will have five year project life. Cost Base = $55,000,000 and Recovery Period = 7-year MACRS

N
1 2 3 4 5 6 7 8

MACRS Depreciation Rate Amount x 000

14.29 % 24.49 % 17.49 % 12.49 % 8.93 % 8.92 8 92 % 8.93 % 4.46 % $7,860 $13,470 $9,620 $6,870 $4,906 $4,906 $4 906 $4,911.5 $2,453

Allowed Depreciation Amount x 000

$7,860 $13,470 $9,620 $6,870 $ 2,453 Total = $ 40,273,000 0 0 0
29

Gains ( (Losses) associated with Asset Disposal ) d h l

Salvage value = $7 000 000 $7,000,000 Book Value (year 5) = Cost Base Total Depreciation = $55,000,000 - $ 40,273,000 = $ 14,727,000 Taxable gains (loss) = Salvage Value Book Value = $7,000,000 - $ 14,727,000 =-$ $7,727,000 Tax credits = [Taxable Gains (loss)] (Tax Rate) [ ( )] ( ) = - $ 7,727,000 x (0.40) = $3,091,000
30

Table 10.1 - Cash Flow for Capstones Micro-CHP Project Based on Most-Likely Most Likely Estimates (Unit: $000, except demand) $000 Income Statement
0 1
80 1,500 $120,000 $120 000

2
80 1,575 $126,000 $126 000

3
80 1,654 $132,300 $132 300

4
80 1,736 $138,915 $138 915

5
80 1,823 $145,865 $145 865

Revenues:
Unit Price Demand (units) Sales revenue

Expenses:
Unit variable cost Variable cost Fixed cost Depreciation Taxable Income Income taxes (40%) Net Income
$60 90,000 8,000 7,860 $14,141 5.656 $8,484 $60 94,500 8,000 13,470 $10,031 4,012 $6,018 $60 99,225 8,000 9,620 $15,456 6,182 $9,273 $60 104,186 8,000 6,870 $19,859 7,944 $11,916 $60 109,396 8,000 2,453 $26,012 10,405 $15,607

... Example 10.1 ...

Cash Flow Statement Operating activities
Net i N t income Depreciation Investment activities Investment I Salvage Gains tax Net cash flow (55,000,000) $16,344 $ $19,488 $ $18,893 $ $ $18,785 (55,000,000) ( 000 000) 7,000 3,091 $28,151 $ 8,454 8 454 7,860 6,018 6 018 13,470 9,273 9 273 9,620 11,916 11 916 6,870 15,607 15 607 2,453

Table 10.1 Cash flow for Capstones MicroCHP Project Capstone's MicroCHP Project
Income Statement 0 Revenues: Unit Price Demand (units) Sales Revenue Expenses: Unit Variable Cost Variable Cost Fixed Cost Depreciation Taxable Income Income Taxes (40%) Net Income Cash Flow Statement Operating Activities: Net Income Depreciation Investment Activities: Investment Salvage Gains T G i Tax Net Cash Flow $ $

Cash flow for Capstones Micro-CHP Project Micro CHP

1 2 3 4 5 80 $ 80 $ 80 $ 80 $ 80 1500 1575 1654 1736 1823 $ 120,000 $ 126,000 $ 132,300 $ 138,915 $ 145,861 60 90,000 8,000 7,860 14,141 5,656 8,484 $ 60 94,500 8,000 13,470 $ 60 99,225 8,000 9,620 15,456 6,182 9,273 $ 60 104,186 8,000 6,870 $ 60 145,861 8,000 2,453 26,012 10,405 15,607

$ $

$ 10,031 4,012 $ 6,018

$ $

$ 19,859 7,944 $ 11,916

$ $

8,484 7,860 7 860 (55,000)

6,018 13,470 13 470

9,273 9,620 9 620

11,916 6,870 6 870

15,607 2,453 2 453

7,000 3,091 3 091 (55,000) $ 16,344 $ 19,488 $ 18,893 $ 18,785 $ 28,151

10.1

TABLE 11.1 Cash Flows for Capstones MicroCHP Project Based on Most Likely Project, Estimates (unit: $000, except demand)

Is this investment justifiable at a MARR of 15%?

$28,152

PW(15%) = -$55,000,000 + $55 000 000 +$16,344,000(P/F, 15%, 1) + . . +$28,152,000(P/F, 15%, 5) =

$11,107,000 > 0
0

$19,388 $16,344

$18,893 $18785

Years

Yes, Accept the Project

$55,000

35

... Example 10.1 ...

(a) Sensitivity analysis: We begin the sensitivity analysis with a consideration of the base-case situation, which reflects the most-likely estimate base case most likely (expected value) for each input variable. In developing table next slide, we changed a given variable by 20% in 5% increments above and below the base-case value and calculated new NPW while other variables were h ld b l d l l t d NPWs, hil th i bl held constant. Now we ask a series of what-if questions: What if sales are 20% below the expected level? What if Operating costs rise? What if the unit price drops from $80,000 to $64,000 (20% drop)? Table, summarizes the results of our varying the values of the key input variables.

Base

(3)

In this graph we can see that the projects NPW is (1) very sensitive to changes in unit price and variable cost, (2) (2) fairly sensitive to changes in demand, and relatively insensitive to changes in the growth rate, fixed cost and salvage value.

10.3
10.1

10.1. 10.3 10.1.

EXAMPLE 11.3 BreakEven Analysis with Excel

10.3

TABLE 11.3 BreakEven Analysis Using Excels Goal Seek Function (unit: $000)

10.3

EXAMPLE 11.3 (continued) BreakEven Analysis with Excel

10.4
10.4

EXAMPLE 11 4 11.4

Scenario Analysis

10.4

EXAMPLE 11.4 (continued) Scenario Analysis

10.4

10.1

EXAMPLE 11.4 (continued) Scenario Analysis

10.4

10.4

TABLE 11.4 Capstones MicrCHP Project Cash Flows under the Worst Case Scenario WorstCase (unit: $000)

10.4

10.5 10 5

10.1 10 1

EXAMPLE 11.4 (continued) Scenario Analysis

10.5

TABLE 11.5 Capstones MicroCHP Cash Flows under the Best Case Scenario (unit: BestCase $000)

Summary y
Often, cash flow amounts and other aspects of investment project analysis are uncertain. Whenever such uncertainty exists, we are faced with the diffi l of project riskthe possibility that an f d i h h difficulty f j i k h ibili h investment project will not meet our minimum requirements for acceptability and success. Three of the most basic tools for assessing project risk are as follows:
Sensitivity analysisa means of identifying the project variables that, when varied, have the greatest effect on project acceptability. Break-even analysisa means of identifying the value of a particular project variable that causes the project to exactly break-even. Scenario analysisa means of comparing a base-case, or expected, project measurement (such as PW) with the measurement(s) for one or more additional scenarios, such as best and worst case, to identify the extreme and most likely project outcomes.

Summary y
Once you set your risk tolerance, you are establishing an upper-bound limit on the portfolios long-term expected rate of return portfolio s return. There is no such thing as a risk-free investment. The challenge is to decide what level of risk you are willing to assume and then, having decided on your risk tolerance, to understand the implications of that c o ce choice. There is far more to the power of diversification than simply spreading your assets over a number of i di t b f investments to reduce risk. t t t d i k By combining assets with different patterns of return, it is possible to achieve a higher rate of return without significantly increasing risk.

HOMEWORK (due next week) ( )

10.1;

10.2;

PROBLEM 10.1
A machine, costing $25,000 to buy and $3,000 per year to operate. will save mainly l b expenses i packaging over six years. Th anticipated i l labor in k i i The ti i t d salvage value of the machine at the end of six years is $5,000. (a) If a 10% return on investment (rate of return) is desired, what is the minimum required annual savings in labor from this machine? (b) If the service life is just five years, instead of six years, what is the minimum required annual savings in labor for the firm to realize a 10% return on investment? (c) If the annual operating cost increases 10% say from $3 000 to 10%. say, $3,000 $3,300, what will happen to the answer to (a)?

PROBLEM 10.2
Lane Construction Ltd. is considering the acquisition of a new dump truck. The trucks base price is $80,000, and it will cost another $10,000 to modify it for special use by the company This truck falls into the MACRS company. five-year class, It will be sold after five years for $20,000. The truck purchase will have no effect on revenues, but it is expected to save the firm $35,000 per year in operating costs, mainly in leasing expenses. The firms marginal tax rate is 40%, and its MARR is 15%. (a) Is this project acceptable, based on the most likely estimates given in the problem? (b) If the firms MARR is increased to 20%, what would be the required savings in leasing so that the project would remain profitable? (c) If the projected annual savings figure is $25 000 would you still $25,000, recommend the project?